Get Ready for Convertible Price Projects
When we see quotes like this from the Globe and Mail, “Investors are increasingly applying pressure on oil companies to trim their investments in oil sands projects,” it becomes clear that a change in how we do business in Alberta is on the horizon. If the investment community is losing faith in our ability to extract oil at a reasonable and predictable cost, our industry is in serious jeopardy.
Cost overruns on construction projects aren’t uncommon of course, and the oil and gas industry in Alberta has not been an exception. It has in fact shown to have one of the worst records for budget overruns of any energy geography in the world. There are a number of underlying challenges that have contributed to this unfortunate track record; but one of the primary culprits has to do with the predominantly cost-reimbursable contract culture that exists in Alberta. This culture creates a challenging environment for projects to stay on budget. The nature of these contracts suggests that there is compensation for all costs incurred plus a rate uplift, with little to no risk absorbed by the contractor for when projects are extended or when they aren’t executed at maximum efficiency.
When the cost-risk is so lopsided like that, the owners face having to bear all the added cost of any inefficiencies, productivity issues and errors that occur with any contractor or engineering firm on the project. There can be dozens of contractors and engineering firms (EPCM) on a project, and with the way contracts are currently structured, everyone just passes their problems up the food chain (even the best, most efficient contractors). Nobody’s innocent of course, and the owners bear a large percentage of the responsibility to ensure projects are run on budget. After all, they’re the ones who have to report to the investment community on why, when and how much.
With the economic squeeze we see today, the oil and gas producers are starting to re-think the way they cost out these projects. I will examine and explain why cost-reimbursable projects have been a popular choice for the oil and gas industry, and what solutions are on the horizon for making projects stay on budget.
Let’s look at how a project is viewed from the perspective of the engineering firm vs. the project owner when using a cost-reimbursable contract. An owner may not have the available engineering work force so often they will contract the work to a specialized engineering company (EP, EPC, EPCM) that will then estimate how many engineering labor hours it may take to complete the project. Under cost-reimbursable there’s no set limit to this, so the project, scope and schedule can become a moving target. In many cases, the engineering firm has very little incentive to be efficient and economically responsible towards the project – which has become a major source of revenue for engineering companies. None of this comes as a surprise to the owner, since they’re the one that created the contract in the first place. For the owner, the primary motivator for the cost-reimbursable system is that it’s one of the only ways to fast- track projects. “Fast-tracking” is when the owner develops the scope and specifications over the duration of the project with a minimum up-front planning. While this approach is great for speeding up the process of launching a project, it introduces greater risk and can subsequently lead to delays and cost overruns.
Alberta is unique in its cost-reimbursable culture. It exists elsewhere of course, but not to the degree and broad acceptance as it does in Alberta. Many would argue that to fix this approach a project owner should just demand fixed price contracts on their projects to drive-down price. However, that would then be passing all of the risk back to the contractors and EPCs, and would eliminate the advantages of fast-tracking projects. As a result, the great middle-ground solution that is becoming more and more popular is the Convertible Priced Project.
In order for an owner to be able to fast track the project but still have controls in place to ensure that there is a better chance of staying on budget, there needs to be time given to the project in order to develop the scope and understanding before there’s enough certainty to convert it to fixed price. What your starting to see companies do is this: they let a project develop and mature naturally and then about 20% to 40% into the project they convert the contract(s) to fixed price. This allows both sides to evenly share the risk and optimize a project’s profitability. Flipping it to fixed price when the project is partially underway eliminates much of the uncertainty on both sides.
Fast-tracking will of course continue to add an extra element of risk since you’re going forward with incomplete information and plans; but ideally the speed to market that you get from fast-tracking will outweigh that risk if you switch it over to fixed once the plans are more complete.
This contract style makes a lot of sense from both the owner and contractor’s perspectives. It also makes sense to the investment community who are looking for more certainty in the ROI of the $billions in projects run every year in Alberta.