Heavy investment in defence procurement by Saudi Arabia has been accompanied by a desire on the part of government to see such spending advance not just the Kingdom’s national security objectives but also its ambitions to become a knowledge-driven economy. Critical to these efforts are foreign expertise and investment in skilled job-creating businesses, and as a result the government set up its Economic Offset Programme (EOP) in the 1980s. Offset rules mandate that successful bidders invest the equivalent of 35% of the value of the technical and service part of contracts in joint ventures (JVs) that will offer high-quality technical jobs to Saudi workers, and the use of Saudi-origin products or components is given priority, unless no such product is available, while subcontractors are also required to use Saudi-origin products in their work.
Opportunities
Consultancy A.T. Kearney expects around 30% of the $1trn that the GCC is projected to spend on defence between 2013 and 2030 to be dedicated to capital expenditure. If the 35% offset requirement were enforced, this would mean potentially $105bn of investment in sectors such as the aerospace and automotive industries, creating more than 280,000 advanced jobs in the wider GCC and 84,000 in Saudi Arabia alone.
Meanwhile, Frost & Sullivan, another consultancy, predicts that Saudi Arabia’s military offsets market will grow at an annual rate of 3.9% to reach $62.6bn by 2021. This growth is attributable to major defence procurement projects such as F-15SA and Eurofighter Typhoon combat aircraft, A330 MRTT refuelling aircraft, BAE Hawk advanced jet trainers, Leopard 2A7 Plus main battle tanks and Piranha armoured personnel carriers.
As a result of this growth, Saudi Arabia is expected to retain its position as the largest military offsets market in the world. Indeed, the Kingdom will increase its share of the top 20 military offset markets from 14.4% in 2012 to 14.8% in 2021, with its two closest rivals, India and Indonesia, projected to account for 11.5% and 9.7%, respectively, of the market. “The private sector has become a lot more involved in the EOP, largely because of its expansion into civilian areas offering new opportunities for companies,” Walid Abukhaled, Northrop Grumman’s CEO for Saudi Arabia, told OBG.
Uneven Results
While the scale of the offset market opportunity is clear, in the past this has not always translated into the desired results. According to data from the EOP, 36 companies had been established with a total capitalisation of $4.5bn by the end of 2006. However, as noted by A.T. Kearney, this pales in comparison with total military capital expenditure of $150bn between 1988 and 2006, which should have produced $45bn-55bn in offsets based on the 35% requirement. The EOP reported the creation of about 6500 jobs, or 120-150 skilled jobs for every $1bn of contracts.
Successful Partnerships
There are several examples of longstanding partnerships being formed under the offset rules that have yielded tangible results for both defence contractors and Saudi Arabia. For instance, a 2014 study by McKinsey highlighted the Boeing Industrial Technology Group that Boeing established in 1985 to fulfil its Saudi offset obligations in relation to the sale of its Peace Shield land-based air defence system. Through this entity, Boeing has partnered with the Saudi Arabian General Investment Authority and participated in education and training programmes in the Kingdom. Boeing has gone on to deepen its business relationships in the region, selling F-15SA fighters and AH-64 Apache helicopters, along with relevant upgrades and sustainment packages to the Saudi government.
British Offset, a joint initiative by the UK government and BAE Systems, facilitated the creation of Synthomer Middle East, a JV between Dhahran Chemical Industries and the UK’s Synthomer, which produces polymer dispersants for the Middle East’s paint and adhesives market. Since it was founded in 1996, Synthomer Middle East has expanded its market coverage more than threefold and opened new export channels and areas of speciality polymer business. The company has also modernised its production methods in order to increase both its manufacturing and bulk storage capacity.
More recently, British Offset has been working with GSA-Environment of the UK and Saudi company Al Khafrah Group to develop safe disposal arrangements for fly ash material generated during the burning of oil for power production and water desalination. The companies are working together to find a way of removing the carcinogenic elements that remain in the ash after burning. Depending on the results of a feasibility study, the ultimate aim is for British Offset to assist the partners in establishing a JV project to process the ash.
Best Practice
Beyond the borders of Saudi Arabia, countries such as Turkey, South Korea and Japan serve as examples of the results that an effective military offset policy can produce. For instance, Turkey partnered with Lockheed Martin in the development of the F-35 fighter, while South Korea and Japan have similarly secured the transfer of important technologies from the US under offset agreements, which then enabled them to develop their own defence industries.
According to A.T. Kearney, the key to ensuring that Saudi Arabia’s military offset programme reaches its full potential rests in getting offset companies to overcome their purely “contract manufacturing” view of operations. This prevents them from “expanding beyond fulfilling the original offset obligation, be it the manufacturing of a particular subsystem; the maintenance, repair and operations of a particular type of equipment; or the maintenance of a software solution. High reliance on a particular system or platform renders the offset company unable to compete in other market segments after fulfilling its offset obligation.”
Incentives
A.T. Kearney recommends that the right incentives for original equipment manufacturers, local partners and offset government agencies need to be in place to create economic development and commercial value beyond the asset being procured at the time.
Such incentives include support for offset companies to expand into adjacent areas in the value chain early in the life of the programme, to seek export leadership and to capitalise on other initiatives taking place simultaneously in Saudi Arabia.
The ownership structure of JV offset companies has a role to play in this too. For instance, the local partner should be encouraged to invest in the development of long-term capabilities, such as through the setting up of an ownership structure that eventually facilitates the exit of the original equipment manufacturer.
It is important for contractors to consider buying countries’ ability to absorb different types of offsets. In Saudi Arabia’s case, this means recognising that the defence sector is at what A.T. Kearney describes as an “initial value chain participation stage, but facing a major opportunity to evolve and create value”. This implies that the Kingdom has reached a point where its defence industry is starting to become less internationally dependent as a result of developing local capabilities, enabling it to advance from simulation to the assembly and testing of more advanced products.
