Projects To See Post Financial Close Cost Hikes Amid EPC Contract Changes
With the majority of engineering, procurement and construction (EPC) contracts now being implemented on an open book conversion basis, as opposed to using the lump-sum turnkey (LSTK) method, a growing number of projects will see cost increases post financial close, MEES soundings indicate. One such example is the Sharq project in Saudi Arabia, a joint venture between SABIC and a consortium of companies led by Mitsubishi, which appointed its bank group in 2005 (MEES, 5 December 2005) and reached financial close in 2006 (MEES, 22 May 2006). The project was originally estimated to cost a total of $3.64bn, but this has climbed by $250-350mn, or around 7-9.6% due to the increased cost of constructing the cracker, MEES further understands.
Demand for EPC services continues to outstrip supply and costs have climbed markedly, but so far, most of the price increases have been in the interim period between a project being announced by its sponsors and reaching financial close (signing an agreement for funding with lenders). “Now, with the open book contracts, project costs can keep rising, even after financing is signed,” said one expert. Cost increases of a few hundred million dollars are not a great concern for Sharq lenders, because the project boasts strong sponsors and an already strong operating record. The Sharq project attracted thin margins of 50 bps for the full 10-year tenor because it was an expansion of an existing operation and thus viewed as a quasi-corporate rather than pure project financing (MEES, 28 November 2005). Nor is the increase problematic for Ibn Zahr, a SABIC affiliate, which will use some of Sharq’s products as feedstock and is contributing increased equity to the expansion (see page 24). However, the upwards climb in project costs could prove problematic for smaller projects with less robust sponsors. Lenders could also become concerned if projects start to see large jumps of over 15% in costs post financial close, warned one banker.
In LSTK contracts too, post-financing costs can increase, but this is less likely and is often related to unforeseen changes in scope, particularly in large projects with multiple units. Contingencies are built into contracts to cover such events and in some cases the sponsors bear the extra costs, while in others the debt/equity ratio remains the same and lenders may also provide more cash. For an LSTK contract the EPC contractor will give the project sponsor an overall cost estimate, so the total project costs are known in advance. This type of contract used to be the mainstay of project finance, but is now little used (See EPC Contractor Sees Raw Material Lead Times/Price Hikes Continuing, MEES, 21 May). If EPC contractors are asked to price on an LSTK basis, they assume the worst case scenario on procurement costs (given the rapid rise in raw material prices and delivery times) and the contract will be pricey, if they are willing to provide it at all. In open book conversion, EPC contractors agree in advance with sponsors a margin or fee for their services, and conduct procurement on an open book basis, allowing the client to view costs. If the client requests it, the books can then be closed (the contract wrapped) at a late stage in the process and converted to LSTK. Thus, for the open book contract, as procurement takes place costs can rise considerably from the original project cost estimates used in the financing as a result of increases in raw materials prices.
