With a large number of projects slated for development in the Gulf concerns have been raised about financial and engineering capacity. First to surface were fears that bank capacity would be insufficient to meet the growing demand; and now the attention has turned to another link in the project development chain: engineering, procurement and construction (EPC) services. Melanie Lovatt attempts to assess whether EPC overload could pose a serious threat to the speedy implementation of energy projects in the Gulf.
The growing concern over the shortage of engineering, procurement and construction (EPC) services was highlighted in March when two of the three consortia bidding to develop Saudi Arabia’s Shu'aiba independent water and power project (IWPP) project pulled out. While there was much discussion of why the two consortia withdrew, MEES understands that the EPC price was the main issue for both the International Power-led and the Tractebel (Suez Energy)-led teams. In some cases EPC services have been coming in over 25% higher than originally budgeted, posing a problem to both developers and sponsors and there have been a large number of hasty revisions of project costs. “Within the space of several months that a project is initially announced and then goes out to the market, we’ve seen so many increases in costs,” commented a banker specialized in project finance.
While the IP and Tractebel teams wanted more time in order to work on a solution to the EPC cost problem, Saudi Arabia’s Water and Electricity Company (WEC) decided instead to proceed and is evaluating the solitary bid from Riyadh based ACWA Power and Malaysia’s Tenagh Nacional Berhad, with the nominated EPC contractors including Doosan Heavy Industries and Siemens, together with a bank team of Saudi Hollandi, Riyad Bank, and Arab Bank (MEES, 21 March).
The desire by WEC to evaluate the bid suggests that even if the numbers of bidders are falling, projects can still push ahead, although presumably only when the costs are close to the original forecast. If all three bidders had had problems with their EPC costs, the bidding process would probably have taken more time. “We might see that in the future, if EPC costs are coming in higher, then consortia may take longer to bid on any given project as they try to use creative ways to lower their costs,” said the banker.
Raw Material Costs
The rising cost of EPC services is partly blamed on the increased costs of raw materials such as steel and cement as a result of the huge construction needs in Asia and particularly China. Speaking at the 6th International Oil Summit in Paris on 21 April, Technip CEO Daniel Valot said the rise in real costs over the last two years was driven by three factors: the rise in relative value of the euro, the 50% rise in maritime freight rates and the 91% rise in steel prices.
There has also been consolidation of EPC providers who suffered lean times in the late 1990s and some, particularly from the US, have been slow to return to the industry. “There is a dearth of mainstream EPC contractors as a result of consolidation in the European industry and a very strong absence of some American contractors,” commented one Gulf power developer. “This leaves a few main European and American players, and increasing participation from South Korea and Japan.” The problem is global and of such magnitude that Andrew Gould, Chairman and CEO of Schlumberger, commented in a paper at the Howard Weil conference in New Orleans in April that the oil service industry is “not in particularly good shape to meet the needs of a rapid worldwide ramp up in activity.”
But mostly, the blame is being put on the volume of construction activity. “The problem is not so much that the contractors are not there – although there has been a restructuring and consolidation in the sector – but that there are so many projects coming to market,” commented a source at a major state oil company in the Gulf. “It’s a capacity issue. But it is not stopping any projects going through.” Adding to the volume is the Iraq reconstruction work. Bechtel of the US had a budget of $680mn approved for the reconstruction effort, which includes $230mn on power restoration and $45mn on water (MEES, 4 August 2003). “Iraq is a significant job,” a Bechtel spokesman told MEES, but pointed out that the company had bid for and won other large Gulf and Middle East projects since it started working on the Iraq contract.
Growing Project Size
The largest problem regarding EPC services is not the volume of work on offer, but the growing size of the projects, according to developers. “Project finance is about risk allocation and the creditworthiness of the EPC contractor is important. Some of the large sized projects are not commensurate with the balance sheet of EPC contractors from a buyer’s perspective,” said a power developer. Only a handful of players are able to handle the really large projects, including the US’ Bechtel, France’s Tractebel, the UK’s IP, Japan’s JGC Corp and Chiyoda, France’s Technip, and Snamprogetti (an ENI subsidiary) of Italy.
Technip’s Mr Valot said that contractors were facing a double squeeze due to the fact that project owners – national and international oil companies – were growing in size much faster than contractors, while projects themselves were growing in size and complexity and costs were rising. Mr Valot said that while shareholders’ equity in the world’s 10 largest oil companies had more than doubled from $243bn to $501bn in the period 1994-2004, a similar measure of the 10 largest engineering and construction companies had grown from just $11bn to $13bn over the period.
To illustrate the increasing size of deals, Mr Valot pointed to major contracts signed by Technip in recent years. In the period 1998-2003 all contracts were well below the $2bn level, but in 2004 Technip and Chiyoda signed for the $4bn Qatargas-2 EPC contract (MEES, 20/27 December 2004). The rising trend is similar in terms of size of LNG trains under construction and the general complexity of work undertaken, with LNG/GTL and deep offshore dominating the order backlog. “Business is increasingly being driven by high-growth, high-tech segments: deep offshore facilities, LNG/GTL and heavy oil upgrading,” Mr Valot said.
However, some are more sanguine about the EPC contractors’ financial muscle. “On larger projects we’ve seen a lot of teaming up of smaller contractors with large contractors,” said the Gulf oil company source, adding, “We are conscious that the shortage of EPC contractors is a global problem, but there aren’t really any issues here because our area is so specialized.”
Problems Are Overstated
One financial advisor at a bank agrees: “To be honest the concerns about a shortage of EPC contractors are overstated. If it is a good project, people will want to do it. There are enough contractors to do the business and to provide competition. There are many projects set to go ahead in Qatar, for example, and they have to be coordinated so that contracting services are not strained, but the reality is that they never all pop at once – they all have different time frames.”
His opinion echoes that of many in the project development and finance business. And even those who are concerned about rising EPC costs and a potential bottleneck in services believe that while such problems could stall some projects, they are unlikely to stop them going ahead. “Just as good projects will attract funding, they’re also likely to be able to secure EPC services, although prices could go up over the short to medium term,” said a project finance expert.
A power developer notes: “It comes down to supply and demand. If there is a shortage companies will move in to fill the gap.” He points out that this is already taking place, with South Korea’s Doosan, which was mostly a desalination company, now seeking more power exposure. And General Electric, which was mostly a turbine supplier, is now edging into the EPC services business in the Middle East as well.
Nevertheless, the EPC conditions can be ‘onerous’ in project finance for power and some oil and gas contracts, admit developers. The EPC contractors typically follow the lump sum turnkey clause meaning that the risk rests with them to deliver the facilities in working order (and tested) as outlined in the contract. They take responsibility for cost and time overruns. If there is a problem on a large project, it could, theoretically, put a smaller EPC contractor out of business. While there have been suggestions about changing the risk-weighting, so that others take on the risk, it would be tricky to make such changes, says a power developer. “It’s easy to say that the sponsors should take the risk, but at the end of the day construction risk is borne by the one who mitigates it best, which is the contractor not the sponsor.” However, for government contracts at the Power and Water Purchase Agreement (PWPA) stage, more risk could perhaps be assumed by the off-taker. Furthermore, there could possibly be a scaling down of some projects, by breaking them into smaller phases.
To mitigate the cost issues Mr Valot said that contractors and project owners had more recently introduced indexation mechanisms to protect against the volatility of raw material costs and had introduced multi-currency contracts, more accurately reflecting the contractors’ multi-currency procurement risk. He said that the two sides had also agreed to reduce penalties as a percentage of revenues on large projects and had structured contractor fees as a cost-plus fee basis, to be converted into a lump-sum contract once visibility on costs improved further into the project.
Talk of a crisis in the provision of EPC services to the Gulf appears alarmist and exaggerated. However, the growing cost of EPC services and a shortage of contractors could complicate projects for developers and sponsors, and may ultimately slow down the implementation of some. But well thought out projects are unlikely to have a problem luring contractors.
