The changing face of Middle Eastern social infrastructure projects: The post-oil-boom economy

In this article we consider the impact that the reduction in oil revenues has had on the infrastructure market of regional Middle Eastern economies, including consequential spending adjustments, and how this shift has also made governments reconsider traditional procurement strategies in favour of partnership and private-finance-based approaches.  

We will be concentrating on the Gulf Corporation Council member states (the Kingdom of Bahrain (Bahrain), Kuwait, the Sultanate of Oman (Oman), Qatar, the Kingdom of Saudi Arabia (Saudi Arabia) and the United Arab Emirates (the UAE) (together, the GCC)). 

For decades, the GCC countries' economies have relied on oil as the main source of export and fiscal revenues. The spectacular collapse in the global oil price since 2014 has led to a significant deterioration in the fiscal balances of the GCC countries. The direct correlation between oil prices and infrastructure spending in the GCC has therefore had a resounding impact on the delivery and growth of current and future infrastructure projects. The obvious challenges are evidenced across the region with many infrastructure projects delayed, cancelled or scaled back. The record lows seen in the oil market have resulted in substantial budget deficits for many previously cash-rich regional governments, causing a widespread halt to many non-profit-producing "social" infrastructure schemes. 

It is these social infrastructure projects that have tended to be procured by governments based on the socio-economic needs of their people, despite the often inherent lack of profitability of the projects themselves. These projects require a different level and nature of government support to pure concession projects in profit-generating sectors such as resources and utilities. Budget cuts due to falling oil revenues are now encouraging governments across the GCC to explore new delivery models and alternative sources of funding for such projects. This article will explore in detail both the general impact of the fall in the oil price in the GCC region as well as these alternative delivery strategies, which must surely become the governments' new reality for social infrastructure project delivery. 

GCC governments' dependence on oil

The price of oil reached a record high of around US$140 a barrel in July 2008. Those highs were followed by unsettled times where the price of oil fluctuated somewhat, before finally stabilising at around US$100 per barrel in the summer of 2014. This US$100 per barrel price spelled good times for oil-rich countries and consequently saw a surge in public spending. 

This reliance on public money for the majority of infrastructure projects in the GCC (both social and economic) has meant that, while governments have had few worries about funding their far-reaching infrastructure agendas, they have also tended to avoid capitalising on the private sector's expertise and project delivery capabilities. Generally speaking, there has been no substantive need, to date, for public-private partnership (PPP) laws to be developed regionally, but now these governments, for the first time, are encountering a new and very real challenge to infrastructure project funding. Following the oil price collapse, governments are being forced to re-assess their typical project funding structures and explore new methods of financing and delivery, all the while ensuring that public projects are necessary, affordable and efficient. 

The inflated oil prices in the 2000s saw rapidly expanding government budgets and spending. This meant that investment in infrastructure projects accelerated throughout the region, as can be seen by the impressive modern skylines of Dubai, Doha, Riyadh and Abu Dhabi, to name a few. With such a high price for a much needed commodity, GCC countries, with their well-developed oil and gas industries, were riding high and planning their infrastructure programmes and budgets based on high oil prices continuing unabated. In the last two years, however, there has been an unprecedented slump: average oil prices were below US$50 a barrel for the whole of 2015 and this continued for most of 2016, despite a relative peak towards the end of the year. In 2015, oil reached record lows of below US$30 a barrel, which wiped US$360bn off the GCC countries' revenue in 2015 and led to an overall GCC fiscal deficit of 7. 9 per cent of GDP.¹ After an initial "wait and see" strategy, when it was hoped that the fall would turn out to be a temporary glitch, GCC oil producers have now come to the realisation that the current oil price decline may not be a short-term phenomenon. Despite recent negotiations between the Organisation of the Petroleum Exporting Countries (OPEC) and non-OPEC countries to reduce supply, there is no certainty of compliance, particularly after the International Energy Agency's (IEA) recent report that OPEC members pumped a record high of 34. 2 million barrels of oil in November 2016. Therefore, as supply continues to outstrip demand, GCC governments are being forced to take action.² The situation has been further exacerbated by a number of factors, including increased production from hydraulic fracking in the US and also with the lifting of UN sanctions in Iran. With daily production of 3. 8 million barrels,³ Iran has nearly reached pre-sanction levels of production, adding to the fears of oil futures trading in backwardation (i. e. where the spot price of oil is higher than its expected future price). 

This decline in the oil price has had a significant impact on the GCC's infrastructure projects and the current lack of abatement in production has done little to ease this, particularly when it comes to social infrastructure spending. The slump has required the GCC governments to completely re-assess their public spending strategies as they are forced to plug revenue gaps in their extensive nation-building programmes the GCC those areas of the economy which are not directly influenced by oil, such as tourism, travel and infrastructure, have been supported and heavily subsidised by revenues generated by the sale of oil and other resources. Although each of the GCC countries has been impacted in different ways and to differing degrees by the slump in oil price, there is a common theme: a significant fiscal deficit and a corresponding reduction in public spending. This has often been associated with far-reaching overhauls of government institutions. For many GCC countries the fall in oil prices has materially impacted their sovereign wealth, with news reports suggesting that, for example, almost US$50bn was wiped off Saudi's foreign reserve in a four-month period in 2015.⁴ Throughout the GCC, sovereign wealth funds have often been a principal revenue source for the funding of social infrastructure programmes. Typically, when times were good, spending would spiral upwards, without regard to the possibility that such funding could ever dry up. The widespread changes of the last couple of years, including cutting back subsidies and welfare payments, putting big-ticket developments on hold, and even the planned introduction of a value-added tax (VAT), were unthinkable even a handful of years ago. With all this in mind it is becoming clear that, unless the GCC governments can act to increase oil prices to above their respective breakeven points, they must implement change or project delivery will stall indefinitely. Recent action by OPEC to reduce production levels has had the desired effect of raising oil prices somewhat. However, this cannot disguise the underlying trend that the price remains generally far lower than previously and is likely to remain so for some time. This requires new thinking at a strategic level from the region's governments. 

Breakeven requirements and the effect on infrastructure

While some infrastructure spending is purely discretionary (and, therefore, may be budgeted down when times are hard), some can be very hard to avoid. For many regional governments this issue is greatly exacerbated by the enormous social pressures being generated by demographic change. The populations of the GCC countries are growing rapidly and, as a result, are overwhelmingly youthful, which creates a huge challenge to regional leadership: these young people require healthcare, education and employment and in most cases the regional infrastructure is incapable of delivering this to the required level. That adds up to an urgent need to upgrade schools, hospitals, parks, airports, roads and railways precisely at the time when the fiscal squeeze is making this much harder to do. As a result, some key themes have emerged on the agendas of many of the region's governments: reform of government institutions and legal frameworks; accessing private sector intellectual and financial capital through PPP/partnership programmes and, above all, the diversification of sources of GDP away from an over-reliance on hydrocarbons. 

A report by Standard & Poor's Rating Services estimates GCC governments "need" US$604bn to fund projects through to 2019, including US$100bn on infrastructure. The actual planned capital expenditure for the region is much lower, at approximately US$300bn, with only about US$50bn earmarked for infrastructure.⁵  

It is important to consider each GCC country's breakeven requirements in order to assess the impact the low oil price has had on each country's ability to spend on infrastructure projects. Governments have been impacted differently across the GCC and this is reflected in the GCC governments' levels of public spending and, therefore, the number of social infrastructure projects delivered. 

Kuwait has the lowest breakeven oil price of all the GCC countries;⁶ it is therefore not surprising that, compared with other regions in the Middle East, Kuwait's robust infrastructure projects market expanded in 2016. 

Other governments, such as Saudi Arabia, the UAE and Qatar, have drawn down on reserves and taken on additional sovereign debt on the one hand (Saudi Arabia in particular successfully placed a record amount of government bonds in 2016), while also imposing spending cuts on the other. This has meant that progress on infrastructure projects has slowed, and contractors, developers and suppliers are facing delays on new developments and payments for work already completed. On the whole, however, infrastructure projects are still viewed positively in the market with hopes for progress in the near future as governments adapt and respond practically to these changing times. It is worth noting that Dubai has already taken progressive and successful steps to diversify its economy. Oil accounts for only 5 per cent of revenues by virtue of a prolonged, concentrated and successful drive to diversify into tourism and other services industries. Other GCC countries would do well to follow Dubai's example. 

Some of the other GCC countries have not been as fortunate as Kuwait and Saudi Arabia and have had no option but to raise debt or cut funding, as they hold relatively low reserves. Oman, for example, posted a larger than expected budget deficit in 2015 at almost 16 per cent of GDP, which widened to 17. 2 per cent in 2016.⁷ By the end of 2017 Bahrain's debt is expected to reach 65 per cent of GDP and, with Bahrain requiring an oil price of US$120 to break even, it is more exposed than most GCC countries to low oil and gas revenues.⁸ It is likely to be some time before the situation in Bahrain and Oman improves markedly, particularly as these Governments have suspended, and in some cases cancelled, local infrastructure projects in a bid to rein in public spending.⁹  

Such breakeven requirements and their impact on infrastructure spending have been clearly reflected in each GCC country's newly released 2017 budget allocations for infrastructure. Dubai's allocation for infrastructure spending increased by 27 per cent compared to the fiscal year 2016, to reach 17 per cent of total government expenditure this year, while Saudi Arabia has allocated nearly US$14bn in its 2017 budget to infrastructure and transport. On the other hand, Bahrain's and Oman's 2017 budgets both focus on austerity measures. Bahrain has been forced to scale back 22 municipal projects due to be completed this year and next, as a result of budget cuts.¹⁰ Oman has been handed one of the hardest-hitting budget statements in recent years, reporting a deficit of nearly US$8bn. However, the budget envisages a major role for the private sector in supporting the nation's infrastructure and economic development. 

The breakeven requirements have had a direct and dramatic effect on each government's ability to fund social infrastructure projects. It is therefore vital for governments to assess their financial models to ensure that: (i) they are not hindered by a long-term fiscal deficit; and (ii) the ambitious social infrastructure projects needed to promote diversified GDP growth are able to progress under a workable financial structure. 

Alternative funding and procurement

Given the breakeven requirements discussed above, it is not surprising that the GCC governments are now exploring alternative funding and procurement options as a priority. In February 2016 Moody's announced that it was downgrading Bahrain and Oman and putting a watch on the four other GCC countries,¹¹ a signal to all regional governments that they are going to have to consider seriously how they can deliver their vast social infrastructure programmes in the face of this new fiscal reality. To boost income, a number of GCC countries have announced the introduction of VAT in 2018. This is, however, unlikely to sufficiently recompense the GCC governments' coffers in the short term given that there have been such significant drops in oil revenues. Therefore, the money for social infrastructure will need to be found elsewhere. 

Export credit agencies (ECAs) are another form of financing that GCC governments are turning to on account of the low oil price. ECA-backed financing structures enable the export and supply of the goods, services and contractors of an ECA's domicile through loan guarantees, or, in some cases, even direct lending, from the agency to an overseas borrower.¹² Previously, the Al Sufouh Tram in Dubai received loan guarantees from ECAs in France and Belgium in support of construction contracts won by their domestic companies, while it has also been reported recently that Kuwait National Petroleum Company has selected ten international banks to provide an ECA-backed loan of over US$5bn, which will be channelled into that country's extensive infrastructure agenda.¹³ It is also believed that ECA-backed financing will represent a large part of the approximately US$7bn that is needed to finance the projects related to World Expo 2020 in Dubai.¹⁴ In particular, Asian and European export credit agencies are increasingly providing funding or finance guarantees to help their contractors secure projects in the GCC region. For example, the US$2. 9bn LNG import and regasification terminal in Kuwait was awarded to a consortium led by South Korea's Hyundai Engineering and Construction, backed by ECA guarantees. 

Japanese banks have also recently become more active in project finance, alongside the syndicated loan market, on account of negative interest rates in Japan. This is, to some extent, helping to alleviate funding limitations on infrastructure projects in the GCC. Furthermore, nearly all the GCC sovereign wealth funds have tapped into the international and/or local debt markets during 2016: Saudi Arabia's record US$17. 5bn bond sale in October; Qatar's US$9bn bond sale in May; Abu Dhabi's US$5bn bond sale in April; and Oman's US$3bn bond sale in June, to name a few.¹⁵ 

Project restructuring has been the other great "post-oil-boom" trend in the GCC region. One way that GCC governments have been seeking to alleviate fiscal pressure is by revisiting the size and scope of each project (to revise it down to a more manageable size) and looking at different project structures for delivering individual projects. This sort of "value engineering" was a universal feature of the GCC social infrastructure market in 2016. A core of these projects will always be considered vital to the public interest, and governments have had to consider alternative project models to bring them to fruition in the current economic climate. 

PPP, whereby a public project is funded and operated through a partnership of government and one or more private sector entities, usually accessing private sector funding (in a manner decidedly different to government loans and ECA funding and guarantees discussed above), is the prime alternative project delivery candidate for GCC governments to consider in the current climate. The attractiveness to government of this delivery model is that the initial capital expenditure to create the asset is funded by the private sector, thus reducing the fiscal strain on already stretched budgets. In addition, it allows governments to reduce their technical and operational risk exposure by transferring this risk to the private sector, which is generally considered better at delivering major infrastructure on time and on budget. 

Governments need to be aware that the PPP model of project delivery is not all "upside". The asset is not "free", and financing will require governments to guarantee debt pay-out should the project collapse. Governments will generally also pay more over the life of the asset, and may also need to provide financial security to lenders in terms of its capacity to pay when it comes to the operational phase. The eventual realisation that the government will be required to make such payments – usually in the form of an availability or performance fee – has been the stumbling block for many regional PPPs. As noted above, the significant capital expenditure requirements of most social infrastructure projects and the understandable reluctance of the private sector to take demand risk on "greenfield" projects means that these projects tend not to lend themselves to "pure concession" structures. This is something which governments implementing PPP programmes for social infrastructure must accept as the price for being able to meet the needs of citizens when the government itself does not have the funds for such large capital expenditure, and appropriate structuring and documentation can always help mitigate government risk to market-acceptable levels. 

It is worth noting as a corollary to the current focus on project delivery through PPP in the GCC region that Dubai and Kuwait introduced new PPP laws in 2015. Qatar's and Oman's PPP and private investment frameworks are currently also being put in place and this issue is under active consideration in Saudi Arabia too. Despite the underdevelopment and absence of a formal PPP regulatory framework in all GCC countries, social infrastructure projects in the region have used PPP structures (or some variant thereof) in the past, including for the Prince Mohammad Bin Abdulaziz Airport in Madinah, Saudi Arabia, and the Queen Alia International Airport in Amman, Jordan. There has always been the appetite for considering alternative project delivery methodologies, but now there is also a material financial driver (and, increasingly, a suitable regulatory framework) for governments to start proceeding at pace with these alternatives. 

It can be expected, therefore, that more PPP structures will enter the market as the process of change takes effect through value engineering, project re-prioritisation, and legal, regulatory and institutional reform. 

A number of alternative project delivery models to traditional procurement and PPP also exist, although these are unlikely to gain significant traction regionally. Just briefly, project alliancing is another example of an alternative form of procurement in the social infrastructure sphere. This model, used mainly in the UK and Australia, involves the equitable sharing of risk and reward, with the government and one or more service providers working together as an integrated team to deliver a project where their commercial interests are aligned to the actual project outcomes.¹⁶ The main principle behind this form of contracting is that the parties share equally in the upside of the project (the gain share) but, more importantly, they also share equally in the losses of the project (the pain share) with no risk-loading under the contract to try and shift risk to the private sector participants. A high degree of complexity is associated with alliance contracting and there is no recourse to litigation or arbitration for the parties involved.Therefore it is unlikely in the short or medium term that GCC governments will look to adopt this model and the focus should, as discussed above, be on PPP-style procurement. Alliancing may be a long-term option for governments once a structured and well-established PPP market has been successfully achieved.

Conclusion

For many years oil revenue in the GCC countries has directly correlated to government spending. As GCC governments have traditionally financed projects from their sovereign wealth, it is unsurprising that the social infrastructure market in particular has been hampered by the decline in oil revenues. As governments begin to explore and embrace alternative partnership and finance-based strategies, in addition to placing much greater emphasis on diversification of sources of GDP, growth in the region's economy will provide further impetus to the social infrastructure market.

The future is, of course, uncertain. The agreement in December 2016 between OPEC and non-OPEC countries to cut production sent oil prices soaring above US$58 a barrel. However, with record high levels of oil being pumped in some countries in November 2016 alone, the price rise is already on shaky ground, undermining the original agreement. Whether the region will demonstrate full compliance with the oil output cut in the short, medium or long term is as yet unclear and untested. However, recent comments by Saudi Arabia's Minister of Energy, Industry and Mineral Resources, that the production cut deal is unlikely to be extended beyond the initial six-month period,¹⁷ has sparked renewed fears that this is not the end of the glut in oil supply, with an estimated two-thirds of the oversupply remaining by the end of this year, should the deal not be renewed.¹⁸ If, however, the OPEC agreement is complied with, there is also a strong possibility that this may trigger a drilling boom in US shale, negating the upward price resulting from such compliance. This is very likely given the Trump administration's First Energy Plan in which it commits "to embrace the shale oil and gas revolution".¹⁹ This climate of volatility and uncertainty will continue to have a huge impact on the delivery of social infrastructure projects in the GCC. It is therefore important that GCC governments mitigate their risks through exploring new delivery models and alternative sources of funding for projects, regardless of a possible contango in the oil price (i. e. where the futures price of oil is higher than its current spot price). Cheaper funding sources from ECAs along with private sector engagement and project involvement, particularly through PPPs, will be critical tools in supporting the ongoing delivery of social infrastructure projects regionally.

The pace of change may vary and fluctuate, but there is significant scope for opportunity and improvement. How each government seeks to capitalise on this opportunity remains to be seen but those governments which get the balance of debt funding and project structuring right will ultimately be the most successful in improving the lives of their citizens, increasing trade and tourism and diversifying their economies away from a dependence on oil, effectively future-proofing themselves against a repeat of the 2015 oil crisis. This should, and must, be the agenda for all GCC governments going forward. 

Co-author: Sophie Kapoor, Solicitor.

Notes 

^{1.  https:www.emiratesnbd.com/plugins/ResearchDocsManagement/Documents/Research/Quarterly%20Jul%202015.pdf}
2.  http://gulfbusiness. com/have-low-oil-prices-changed-the-gccs-spending-patterns/
3.  http://themarketmogul. com/what-the-future-holds-for-iran/
4.  http://gulfbusiness. com/saudi-lost-49bn-of-foreign-reserves-in-4-months-due-to-low-oil-prices/
5.  http://www.ogj.com/articles/print/volume-114/issue-2c/general-interest/the-editor-s-perspective/low-oil-prices-push-liberalization-of-gcc-project-finance. html
6.  http://gulfnews.com/business/economy/uae-least-vulnerable-among-gcc-countries-to-oil-price-decline-1. 1354071
7.  https://www.fitchratings com/site/pr/1017155
8.  http://www.kuwait.nbk.com/InvestmentAndBrokerage/ResearchandReports/$Document/MonthlyBriefs/en-gb/MainCopy/$UserFiles/EB_BahrainMacro_2016_0412E.pdf
9.  http://www.tamimi.com/en/magazine/law-update/section-14/december-january-3/gulf-cooperation-council-countries-continue-to-offer-favourable-environments-for-foreign-investment.html
10.  http://www.constructionweekonline.com/article-42455-bahrain-scales-down-22-projects-due-to-budget-cuts
11.  http://www.economist.com/news/middle-east-and-africa/21695539-low-oil-price-manageable-short-term-gulf-states-must-make
12.  http://gulfbusiness.com/gcc-governments-enlist-export-credit-agencies-fund-mega-projects/
13.  http://www.hydrocarbonprocessing.com/news/2016/12/kuwaits-knpc-mandates-banks-for-eca-backed-club-loan
14.  http://gulfbusiness.com/gcc-governments-enlist-export-credit-agencies-fund-mega-projects/
15.  http://www.constructionweekonline.com/article-41968-finding-funding-for-gcc-infrastructure-projects/
16.  http://nvfnorden. org/lisalib/getfile.aspx?itemid=584
17.  http://gulfnews.com/business/sectors/energy/opec-deal-unlikely-to-be-extended-due-to-compliance-saudi-oil-minister-says-1.1963000?utm_content=1.1963000&utm_medium=RSS&utm_source=Feeds&utm_campaign=Opec+deal+unlikely+to+be+extended+due+to+compliance%2C+Saudi+oil+minister+says&localLinksEnabled=false&utm_term=Most+viewed+RSS+
18.  http://oilprice. com/Energy/Energy-General/Oil-Prices-Slide-As-Saudis-See-No-Need-Of-Extending-OPEC-Deal.htm
19.  https://www.whitehouse.gov/america-first-energy