As demand for engineering, procurement and construction (EPC) services continues to outstrip supply and costs ratchet higher, project sponsors and financiers are not the only ones facing challenges. Contractors constructing the growing list of new projects are also subject to procurement pressures as prices and lead times for raw materials and basic engineering items escalate. US contracting giant Fluor expects a continuation of this upward trend. Fluor Vice President, Project Development and Investments, Valerie Colville, discussed the phenomenon in an exclusive interview with MEES,after outlining the key themes in a presentation to the Projects International conference organized by ICBI on 17 April in Paris.

While the increase in raw materials prices has been blamed for much of the escalation in project prices across the globe, the climb has been difficult to quantify. However, recent data from Fluor Corporation, the only A-rated publicly-traded engineering company, helps illustrate the magnitude of the increases in both price and lead-times and suggests they are set to continue their upwards trend. This is unwelcome news for sponsors in the Gulfs oil and gas industry, which is struggling to forecast costs as it implements a large slate of mega-projects.

Fluor has estimated the approximate increases based on an analysis of global materials; and while the company stresses that specific products and regions will show differences, an overall upwards trend is clearly present. While such information is often proprietary, Fluor supplied MEES with information on four basic product areas: fabricated structural steel, pumps/compressors, pipe (seamless welded) and pressure vessels/heat exchangers. Fluors data shows that prices for fabricated structural steel have increased 60-70% in 2003-06, and they are forecast to see another 10-20% increase in 2007-09. Delivery times have increased by 18-20 weeks in 2005-06 and are forecast to remain at that level throughout 2007. Pumps and compressors, depending on type, have seen a 24-45% cost increase in 2003-06, and are estimated to see another 20-40% increase in 2007-09. Delivery time for these products has increased from 18-25 weeks in 2005-06 and is estimated to see another 6-20 week jump this year (Fluor notes that values are neither cumulative nor compounded).

Pipe (seamless and welded) has seen costs climb 80-160% in 2003-06 and is forecast to see another 15-50% climb in 2007-09. Lead times have climbed by 12-30 weeks in 2005-06 and are forecast to extend by another 10 weeks in 2007. Pressure vessels and heat exchanges saw a 30-50% increase in cost in 2003-06, with prices forecast to climb another 20-45% in 2007-09. Lead times were up 26-88 weeks in 2005-06 and are forecast to remain at that level in 2007. The recently launched IHS/Cambridge Energy Research Associates (CERA) Upstream Capital Costs Index (UCCI), one of the few published benchmarks for the rising costs, supports these findings, although with its inclusion of nine primary drivers of capital cost, it is broader-based than the Fluor data. Since 2000, the UCCI has risen 67%, with most of the increase seen in the last two years, and it is set to achieve an all-time high in 2007, according to IHS/CERA estimates (MEES , 19 February).

While the Fluor data varies across product type and region, the figures give an approximate indication of the magnitude of the situation. Only creditworthy sponsors and projects can sustain these increases, said Ms Colville, noting that projects in the Gulf were still proceeding as a result of their low cost feedstock and strong government support. However, MEES soundings indicate that some Gulf experts are already questioning the economics of certain projects at such high implementation costs, even given the cheap feedstock advantage. And it is questionable whether all governments will continue indefinitely to support project development by private investors through provision of cheap gas.

Ms Colville cautions that in this market, projects should have compelling underlying economics and marginal transactions will be challenged to attract serious participants such as leading EPC firms. While Fluor has a global network that boasts strong buying power and can tolerate the high raw material prices more easily than some of its smaller competitors, current testing market conditions have prompted the company to be more selective. The sponsors have to work with those who understand the reality of the price increases and the schedule increases not only for the specialty materials, but also the basic materials, Ms Colville stressed. In addition to the pressures on raw materials, labor markets are also under strain, she explained, adding that the aging EPC workforce presented a challenge in some markets. For example there are some projects where the average age of a worker is 48 and a foreman is 52. Globally, the engineering and construction industry is stretched to its maximum capacity and contractors are caught in a perfect storm, she said. All the sectors of the oil and gas industry upstream, processing, refining, petrochemicals and chemicals are in an unprecedented up-cycle simultaneously. This hasnt happened before in the oil and gas industry for years, she added. The chemical industry, in particular, is seeing unparalleled growth over an extended period or super cycle.

Open Book Conversion Contracts Favored

Increased lead times and prices are fundamentally changing the EPC business. As a result the lump sum turnkey contract (LSTK), which has been the mainstay of much project development, is no longer typical. Most recent contracts are open book conversion, where EPC contractors agree with a sponsor in advance a margin or fee for their services. EPC contractors then conduct procurement on an open book basis allowing the client to view costs. The books are closed (the contract is wrapped) at a late stage (with around 85% of the engineering completed) and then converted to LSTK, and only at client request. Amid rising materials costs, project sponsors find that open book conversion contracts are a more cost-effective option. If EPC contractors are asked to price on an LSTK basis, they will assume a worst case scenario on procurement costs, and the contract will be pricey, if they are willing to provide the LSTK at all. If a bank wants an LSTK at the early stages it is going to be very expensive, explains Ms Colville. Project sponsors and financiers must be cognizant of current market conditions. Its not necessarily buyer beware but buyer be informed, she told MEES , noting that some banks were still expecting wrapped contracts, which was not in the interest of sponsors or contractors during this stressed build-out cycle.

Given the current procurement challenges, she also appealed to export credit agencies (ECAs) to remain flexible when they assessed projects for funding eligibility. Despite todays bank liquidity, ECA finance remained a mainstay for many regions and for large sized projects. Given their diligence process, an ECA brings a lot of credibility to a projects financing, she said. Different ECAs look at content eligibility differently. Some say if it is made in their country they will finance it, others say if it is made by their country they will finance it, and others still say if it is made possible by someone from their country they will finance it. While some ECAs are accommodating there could still be a bit more flexibility agency to agency, she suggested. 

Even in countries like Saudi Arabia, host to many financially strong companies, ECA financing can provide a useful financing top-up on mega-projects. Across the energy market, most projects are increasing in size and complexity, with most now costing over $1bn to construct and some needing several billion dollars to complete. Even large EPC contractors like Fluor do not have balance sheets large enough to build and manage them alone. As a result, giant petrochemical projects such as Yansab and Kayan in Saudi Arabia are being constructed by multiple EPC contractors. There is also a general push in many countries to increase local content, which puts additional pressure on leading EPC contractors to find solid, well performing local companies to work with, Ms Colville said.