4.6.2.1 The economic cycle
Although economic conditions are outside the control of the operator, an evaluation of the level of economic activity at the moment when the main contracts are awarded can provide useful guidance on the mean price levels likely to apply.
Since the lead times involved in decision-making and the realisation of petroleum projects are long (3 to 5 years) investment decisions are taken on the basis of long-term economic calculations, and there is no direct correlation between the costs of platforms under construction and the price of crude. The costs of platforms are more sensitive to the costs of raw materials (particularly steel), the order books of the companies concerned and the availability of large construction yards.
Since 2003, the petroleum services sector has entered the high phase of an economic cycle with very strong demand and insufficient capacities to answer to this demand.
Prices quoted for a given contract will vary by 20–30% but can go over 100%, depending on the state of the market. The firm awarded the contract may just be seeking to cover its operating costs to avoid closure. Or alternatively in overheated economic conditions the firm may have won the contract without any real competition, since the order books of its competitors were full. This is illustrated by the example of Korea, which dropped its
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construction prices by 35–40% in 1998/1999 in order to maintain an acceptable level of activity, whatever the cost, during the Asian crisis which began in 1997.
It should be noted that at times in the economic cycle when prices are high, labour also tends to be in short supply, there are delays in obtaining supplies and in construction work;
these factors tend to further increase project costs.
Since 2004, the increase in costs has been very high. As we have shown in Figure 4.25, the technical costs have reached in 2008 a level of $18 per barrel. A limited decrease has been observed in 2009 and 2010.
Once the project has been defined, the final capital cost can still be affected by various factors and circumstances, in particular the contractual strategy adopted when the main contracts are awarded, the organisation of the teams and project control.
4.6.2.2 Contractual strategy
The expertise and experience of the prime contractor will help him to develop a contractual strategy appropriate to the nature of the project.
A petroleum development involves the award of large contracts for a variety of works (studies, supplies, construction, civil or offshore engineering, etc.). The overall strategy for distributing these various activities between different contractors should be the subject of a general study by the company managing the project, so that the overall project costs and timetable can be optimised. It should be noted that this process induces a delay between services price rises and impacts in the cost of oil companies. This contractual arrangement has limited the increase in the technical costs: projects decided in the last 5 years have still an effect on these costs due to the long development phase. This strategic study, carried out at the start of the project, is usually referred to as the Project Execution Plan (PEP). The final cost of the project will depend to a great extent on the choices made at this stage.
This point is illustrated by showing how two of the traditionally important parameters of the PEP can affect the ultimate capital costs. The first of these parameters is the method by which the various contracts are remunerated. The second is the maintenance of competition between contractors in all the project stages.
A. Different methods of contractual remuneration
The various contracts will be awarded within a framework which includes remuneration terms appropriate to the circumstances.
There are traditionally three bases of remuneration, as follows:
– A time and materials basis, under which the contractor is remunerated based on time spent (day-rate contract);
– A foot-rate contract, where remuneration is based on measurable outputs;
– A fixed price for the entire work, including the contractor’s profit (turnkey contract).
Each of these forms of remuneration has its particular advantages and disadvantages.
A day-rate contract gives management great flexibility in the way the work is organised:
the project manager is free at all times to re-orient the work of the contractor as he sees fit.
However the latter has no particular incentive to complete the work quickly and at minimum cost because this is of no advantage to him. There is therefore a tendency for costs to mount and timings to slip relative to the initial estimates.
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This contractual basis is appropriate to phases of the study in which the basis of the project, and therefore the work required of the contractor (at this stage, consulting engineers), is still subject to great variation. These phases are not the most costly part of the overall project, and it is vital that the necessary resources are made available and that the work does not suffer as a result of relentless cost-cutting. This is the time when the installations to be constructed are being defined technically, and the quality of this work provides the best guar-antee that the project will be completed within budget and on time. For large construction projects, on the other hand, day-rate contracts should be avoided, as overruns on multi-million dollar projects can be extremely costly.
In a foot-rate contract the contractor is remunerated according to measurable quantities of work carried out (volumes of earthworks, tons of piping installed, etc.) based on a unit price schedule appended to the contract. This form of remuneration may be appropriate in the initial phases of construction when the works have still not been fully defined and a fixed price cannot yet be set.
This form of contract only passes part of the financial risk to the contractor. It also presents similar risk of overruns to the day-rate contracts.
Unlike a day-rate contract, a turnkey contract remunerates the contractor for the supply of a complete installation (where appropriate with performance guarantees) without reference to the time spent and materials used. Only the result counts. The contractor has to estimate the cost of the proposed works on the basis of a call for tenders prepared by the petroleum company, and prepare a fixed-price bid for carrying out all the work, including an element which compensates him for his risk, and his profit.
For the oil company, this formula has the merit of constituting a formal commitment on the part of the contractor to complete the work on time and at minimum cost. The fact that the contractor has to bear the cost of an overrun gives him every incentive to keep to the initial estimates.
The oil company needs to be aware of the fact that if a turnkey contract is to be effective the work to be carried out must be defined in a precise, complete and definitive manner. Any work not covered by the contract is likely to be billed at a rate which reflects the fact the contractor will be the only one able to carry out the work required.
Turnkey contracts are therefore suitable during the construction phase when the design and technical studies have been completed and the project definition has been “frozen”. In practice it is often necessary, in order to stick to the timetable, to award contracts before the definitional studies have been fully completed. In such cases it is up to the oil company managing the project to ensure that the timing is such as to ensure an optimum trade-off between cost and time.
In the foregoing we have presented a simplified picture of the various contractual options open to oil companies in implementing development projects. In reality it is up to them to adapt, mix and coordinate these various possibilities depending on the realities of the situ-ation, so as to optimise the overall economics. Particular attention is needed to ensuring that the various contractual interfaces between the petroleum company managing the project and its main subcontractors are clear and well coordinated. Special care needs to be taken that responsibilities are well delineated, and that there are no overlaps or gaps.
B. Maintaining competition between contractors
The other vital measure in reducing the final cost of a project is to maintain competition between contractors when contracts are awarded.
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The price of executing a project can vary significantly (i.e. by 20–30%) depending on whether or not there is genuine competition between contractors or the price was imposed by a contractor acting monopolistically. If it is not careful, such a situation may be of the oil company’s own making, as illustrated in the following examples.
a. Design of the modules of an offshore platform
The trend within the oil industry to design ever larger and heavier modules in order to minimise the need to link up separate modules was in itself a good idea. However this idea was taken to extreme lengths, so that modules became so large that there remained only one contractor with the necessary equipment or a lifting barge of sufficient capacity, with the result that prices became prohibitive.
b. LNG plants
Over the years petroleum companies have got into the habit, for reasons of technical conformity, of using the same proprietary liquefaction process and the same contractors for the construction of LNG plants. A quasi-monopoly has therefore arisen between a few contractors, and this has pushed prices artificially high. This situation has in turn tended to reduce the number of new LNG projects which are economically viable. The entry of new, or the return of existing, contractors into the market and the emergence of new proprietary processes should lead to appreciable cost savings.
4.6.2.3 Organisation of the project team
A project is usually put in charge of a project manager whose objective it will be to erect high-quality installations quickly (to an agreed timetable), within (if possible below!) budget, which meet the initial specifications.
Alongside this basic objective the project manager must also ensure that a number of other ongoing requirements are met, such as workplace safety, environmental protection, plant security, quality and reliability.
The project organisation must have regard to these different constraints, but will be heavily influenced by the contractual strategy adopted. The project manager will in any case monitor the critical activities directly, as far as management is concerned, by keeping tabs on the costs and planning, and in the key technical areas, which are often metallurgy, instru-mentation and power.
Costs will be controlled particularly tightly. This will be achieved by using specialist software which allows rigorous budgetary monitoring and an ongoing exchange of data with the different groups involved with the project, whether from the client organisation or the financial department of the company.
The measures to control project costs will be accompanied by a series of reviews or internal or external audits aimed at optimising the safety and the quality of the installations under construction. Given the magnitude of the investments involved in petroleum devel-opments, all oil companies have developed strict and planned control procedures in these areas.
In some countries, local content policy means that much of the investment is made in the local market. In that case, international service companies need to establish a permanent local presence to get fully involved. However, questions exist around the ability of the supply sector to meet demand in term of local equipment and local human resources with the adequate skill sets.
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4.7 THE PETROLEUM SERVICES SECTOR
The petroleum services sector, or more fully the upstream oil and gas supply and service industry, is not easy to define as it embraces activities of a very heterogeneous nature. It includes geophysical activities (the acquisition, processing and interpretation of seismic data), drilling and associated services, engineering and design, subsea engineering (pipeline laying) and the construction of platforms (shipyards). In addition there are hosts of manu-facturers of tools (for geophysics and drilling), metal construction and mechanical engi-neering firms. What all these companies, whether large, medium-sized or small, have in common is that they provide a service or services to the petroleum industry.