Contracting Out Risk and Optimizing Oil and Gas Value Chains

June 16, 2010. With oil and gas construction suddenly under the spotlight following the unfortunate events in the Gulf of Mexico and a major producer in the dock for previously unheard of compensation claims, it seems likely the industry will become even more risk averse in the construction of new plants and equipment.

Even before the Gulf of Mexico event, global competition for depleting resources and a more constrained credit environment as a result of the financial crisis were already adding pressure on the oil and gas industry to lower operating costs and to increase finding and recovery rates. Price volatility, changing energy policies and supply-demand imbalances only added to the increasingly complex challenges in the exploration and development of energy resources.

Successful execution these days involves paying attention to technical, financial, environmental, logistical and cultural variable. In the area of contracting, decisions need to be made on how to split works and services appropriately between specialized contracted parties, depending on project objectives and risk tolerance levels.

Determining factors often include:

  • Type, location and size of project
  • Risk allocation between owner and contractor
  • Division of responsibilities
  • Interfaces
  • Market situation
  • Splitting of work and services between the concerned parties
  • Project time constraints
  • Owner’s existing organization and resources

The key is whether to keep overall management in-house or outsource to third parties. There are several contracting options in the market, with the recent emergence of competitive lump-sum pricing contract on top of the predominant EPC, PMC and PLS models.

Which is the better solution for today’s market environment?

Engineering, Procurement and Construction (EPC) Contract StructureDiagram 1

Engineering, Procurement and Construction (EPC) contracts help provide “˜turn-key’ systems for oil and gas companies.

In EPCs, a single-point contract is awarded which includes the entire supply of materials and equipment; all design, engineering, procurement, construction and installation works as well as commissioning, start-up, training, acceptance and testing activities.

Due to a single point of responsibility and an all-encompassing contract, almost all risk is transferred from owner to contractor. There are guaranteed completion dates, performance and firm contract prices, and clear division of obligations and liabilities. Contract prices tend to be high, due to mark ups and the transfer of risks. The relatively long tendering period and initial engineering phase may impede schedules.

Project Management Contract (PMC) Structure

Diagram 2

PMCs on the other hand, contract out some of the management aspects. For instance, KBR, the engineering, construction and services subsidiary of Halliburton, undertook the PMC work in a joint venture with JGC of Japan, incorporating the services of MWKL, a KBR/JGC subsidiary for Shell’s Integrated Gas-to-Liquids project in Qatar.

PMCs are often used to provide a layer of professional management and control to the full cycle of a construction contract – from design and specification through construction and snagging to handover. The benefits of this more complex contractual relationship is that professional construction expertise is available to the owner throughout the process including the handling of the bidding by contractors process and coordinating the work of different contractors through different build phases. The award of a PMC should ensure a swifter delivery of highly complex construction projects, and is often required for major new build complex construction projects by the lenders who are providing the project financing. The downside of this type of arrangement is that the Project Manager will expect a separate fee but this should be recovered in efficiency saving and better coordination and management of the overall construction contract.

PMCs should also ensure lower construction contractor costs in comparison to an ECP single point contract, as the owner is carrying all of the risk and cost control is the responsibility of the Project Manager.

Engineering, Procurement, Construction Management (EPCM) Structure

Diagram 3

EPCM contractors develop the design, execute the procurement process and are the representative on behalf of the owners. They manage all contracts and the construction processes under their name. The contractor also assists in all negotiations to create direct contractual relationships between owner and construction contractors and major material suppliers.

EPCMs allow owners to retain more control, but also more risk. This means that owners need to have experienced in-house teams to oversee the EPCM contractor’s management of these complex contracts. They also have the opportunity to influence EPCM contractors’ business outcome, due to the direct integrated relationships.

As a result, the contractual, schedule, cost and technical risks rest almost entirely with owners. There are no mark ups and owners get more competitive market prices for deliveries, all materials, equipment and works. With overall control remaining in the owners’ hands, a more complex web of coordination and communication is needed between numerous interfaces and multiple contracts.

With a more complex contract structure however, come potential gaps in risk allocation and missing works and services.

Project Lump Sum (PLS) Structure

Diagram 4

In a PLS contract, an entire project will be separated into pre-agreed stages, which are then awarded on lump sum basis within the scope of an EPC contract. After the completion of every pre-defined milestone, the contract price for the next stage is renegotiated, re-evaluated and adapted through cost estimates and proposal whose accuracy becomes incrementally more precise through the increased project knowledge. The overall contract price for the entire EPC project is progressively adjusted for variations and changes in scope and extent.

Owners enjoy the advantages of a traditional lump sum contract with a minimal risk for claims, without having to define the scope of the project in its initial phases, as is the case with traditional EPC contracts. There is greater flexibility in defining project details, terminating projects or changing EPC contractors. With progressive price and scope adjustments, there is greater costs transparency and price security. Perhaps the only down-side is the increased effort needed for renegotiation and coordination.

Whether competitive lump-sum pricing becomes a reality depends largely on whether contractors believe the current market conditions will be short lived and evolve in their favour.

Conclusion

With oil and gas construction suddenly under the spotlight following the unfortunate events in the Gulf of Mexico and a major producer in the dock for previously unheard of compensation claims, it seems likely the industry will become even more risk averse in the construction of new plants and equipment.

The producers are more likely to stick to their core competences of discovering and refining new reserves and will increasingly leave the construction of new plant to those construction companies with a long track record of successfully delivering new plant on time and within budget. Thus, we believe that single point contracts and PLS contracts will become the norm in the industry as the producers endeavor to push more of the risk onto their contractors and the contractors can expect to earn their increased margins through assuming this risk.

Oil and gas industry players, including oil companies, engineering, procurement, and construction companies, suppliers and service vendors, need to “up their game” by focusing on things that they do best and improving their own capabilities to create win-win situations.

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