An escalating problem

This article was written by Sachin Kerur, International Construction & Energy Partner, Masons Galadari (Dubai). 

To be a pricing estimator in the Gulf construction market today is no easy thing.  Even when many thought 2006 would see a stabilisation of prices, steel prices rose to between $585 to $615 per tonne by the middle of the year, a 65% per cent increase in the six months from the start of the year.

The problem for contractors and suppliers working in today’s volatile materials market is that estimating, bidding and financing major construction projects in the Gulf is a challenge and many face significant losses or erosion of anticipated profits because the majority are locked into fixed-priced construction contracts where they bear the risk of material price and supplier cost increases.   A surge in material costs will affect their bottom lines considerably where profit margins are not as high as they once were.

Without a price escalation clause that allows for an adjustment to the contract price if there is an unexpected rise in the market prices of key construction materials, a contractor will have a difficult, if not impossible task in getting respite from such increases.  Even if the contract has become economically burdensome, that is unlikely to be sufficient to excuse performance.  

Many contractors faced with losing all of their profit or worse, claim that the contracts are impossible or frustrated.  However legal doctrines such as "impossibility", "commercial impracticability", "frustration of purpose", "force majeure" all of which have much in common, require the facts to satisfy well-established criteria.     Under most legal systems, a party may be excused from performing an obligation under a contract if performance becomes "impossible" because of an unexpected event.  On the other hand Courts will not apply the doctrine of impossibility just because performance of the contract has become more expensive than previously anticipated. 

A number of contractors, wrongly, believe in the ability of the force majeure clause of a contract to come to their rescue. A force majeure clause protects parties if part of the contract cannot be performed because of some exceptional event, outside the control of the parties and which could not have been prevented by the exercise of reasonable care.   Construction contracts typically include force majeure clauses but generally these clauses only allow a contractor additional time to perform.   Therefore whilst a force majeure clause may enable a contractor extra time to obtain materials that are in short supply, it is unlikely to assist him if he is forced to pay much higher material prices than he originally estimated. 

The truth is that Courts in this region generally do not easily allow a party to escape a contractual obligation. Fixed-priced construction contracts allocate risk and without a specific clause allowing for changes in prices, Courts tend to insist that contractor must execute the contracted work at the price agreed. 

In the current economic climate, tender prices for EPC contracts are soaring and contractors argue that the only way owners will get more competitive bids is to share more risk.  Very few owners are listening.  For an owner the idea of drafting a price-escalation clause in a contract may seem like writing a blank cheque, even though he may benefit in the end.  If the contract is based on current prices charged to the contractor and any actual increases, rather than a fixed-price quote with wild speculative contingencies, owners might save money. 

Assuming owners are receptive to the idea of price-escalation provisions, what considerations should the person drafting such provisions, have in mind?   The clause should identify the specific materials considered to be volatile and the unit prices for such materials at the date the contract is executed. Typically the clause should provide that the owner will become liable for any price increases in those materials that cause the total contract price to be increased by an agreed percentage.  A sensible clause will set out notice periods for identification of price increases and to avoid arguments later on, identify the class of documentation evidencing the increase, what events trigger an increase in contract price, what is the appropriate measure of market price, how many times the contract price can be increased and what are the time periods covered.   

For those contractors who have been successful in negotiating price escalation clauses, the story does not end there.  These clauses will typically have a series of notice and documentation protocols which must be followed strictly to be effective and to avoid accusations that bad purchasing practice by the contractor is to blame for price hikes. 

But what if owners do not respond to industry concerns and refuse to agree to price escalation clauses. Contractors will need to take steps to limit their exposure.

By fostering relationships with established and reputable suppliers, perhaps when prices and availability become an issue, such suppliers are likely to be more accommodating in sourcing material at an economic price.  Even when reliable supply chains have been established, contractors must ensure that commitments received from their suppliers mirror their obligations to the owners.  Suppliers quotes should be vetted carefully as they may have provided bids on materials that are now unavailable or have increased significantly in cost and contractors will not wish to be left picking up the tab.

It is also important for contractors, particularly those working away from home, to be adequately tuned into the local Gulf markets.  In this way they will be more alert to developments that could impact future prices and which point to trouble brewing.    Such market knowledge may suggest the need to buy materials in advance.  Of course this can bring its own problems such as draining cash flow and increasing storage and security costs.  However it may be a sensible precaution on contract award to buy price-volatile material, perhaps negotiating delayed delivery times, to avoid storage costs. 

Many local Gulf companies are now searching for cheaper prices outside the region rather than have to face local prices.  Gulf contractors are also choosing to only bid on projects with short construction programmes which give prices less time to increase.   This may inevitably affect regional growth and development plans and therefore developers may now be more open to new contract practices.

For media enquiries contact :

Lakhbir Rakar
CM PR Advisor
Pinsent Masons
Direct Dial +44 (0)121 260 4005
Fax +44 (0)121 626 1040
E-mail lakhbir.rakar@pinsentmasons.com