Oil and gas project procurement
Oil & Gas industry is highly driven by projects, which imply construction of hydrocarbon production, transportation and processing facilities. Projects vary in size, complexity and costs. Today, a US$500 million project became a norm, and anything above US$1 billion, also called mega projects, is no longer record-breaking achievements.
A number of various parties involved in the project execution, i.e. Project Owner / Client, Main Contractor, Subcontractors, Suppliers, Manufacturers, Banks, Project management consultancies, Engineering & Design houses and many more. An array of risks involved in the project planning and execution is huge and diverse, hence adopting the right risk management approach is important. As a result, selecting the right procurement strategy/delivery method to suit a particular project is of utmost importance. Very often, a large project would be split into packages (e.g. living platform, pipeline, processing facility, wellhead platforms) to allow a more competitive environment, access to the right technical expertise, fabrications yards, installation equipment, to name a few.
How this is done
Generally, a project consists of several phases, as shown below.
Studies and basic design are done long in advance, to understand if initial assumptions make sense, which then leads to a concept selection, i.e. which technology to use for a project. This stage is also called as front-end loading (FEL) stage and represents the best time during the project lifecycle to make a change that will significantly impact and help to optimize cost, time and resources for the entire project. Hence, this is the phase whereby the most attention shall be given to ensure the project success.
This is followed by Front End Engineering Design (FEED) (also called basic engineering design) that is used as a basis for tendering. In addition, FEED provides an insight into investment costs and improved visibility study, prior to any further advancement with the project. A well-written FEED can take up to one year to produce and would provide less ambiguity for EPC contractors and result in less execution risk, less scope and price changes. All those factors contribute to better prices obtained during bidding stage. The FEED stage can be done via a competition between engineering houses, or through a preferred technology provider (a particular type of technology that is favoured by the project owner).
Execution stage is where the actual work is happening with detailed engineering, procurement, construction and commissioning activities peaking and slowing down depending on the project phase. This is the most challenging and high-risk stage, yet a good FEED will result in a more flawless execution. Once the construction is finished, facilities are commissioned, tested and accepted by the project owner.
Defect-correction period is the next step during which any shortcomings during the construction phase are found and resolved. Depending on the commercial arrangements, long-term warranties, facility management services may be provided by the same EPC contractor who delivered facilities.
Project Management is central to ensure projects are executed as planned and there are methodologies how this is achieved. In addition, taking a stage-gate approach is a proven method to manage large projects effectively. The stage-gate philosophy requires having a process with clear and defined milestones and deliverables for every project stage that must be approved and accepted, prior to moving to the next phase.
There are different types of methodologies and models on how to approach project procurement. They are broadly divided into Lump Sum, Cost Reimbursable, Time & Material, Alliance / Relationship. Each of the main approaches would have different contracting strategies, cost and schedule risks and scope uncertainty. In addition, the degree of involvement of each party varies significantly, from a full project owner involvement to a minimum participation. Selecting the right project delivery strategy has a direct impact on the success rate of projects. Analyzing project objectives, project owner capabilities and organizational culture, and assessing available delivery (contracting) options, will tremendously improve project success.
Typical Project Delivery Methods and Strategies
- Project Procurement
- Fixed Price / Lump Sum Turn Key
- Engineer, Procure, construct (EPC)
- Engineer, Procure, construct with Long Lead Items (EPC with LLI)
- Engineer, Procure, construction management (EPCM)
- Cost Reimbursement
- Cost-reimbursable contract with an incentive fee
- Cost-reimbursable contract with a fixed fee
- Cost-reimbursable contract with a percentage fee
- Cost-reimbursable contract with award fee
- Alliance / Relationship Contracting
- TIme & Material
- Engineer, Procure and Construct (EPC) is a method whereby the main contractor is selected to act as a single point or coordination, to engineer, build and deliver a facility at an agreed lump sum price within the agreed timeframe. This is less risky, but the highest cost for project owners, due to scope changes during the implementation and highest risk to contractors, whereby this risk is priced and passed on to the project owner as part of the quoted lump sum. The schedule and budget risks lie with the EPC contractor. The EPC concept is best used for very well defined projects with clear scope and little unknowns.
- Engineer, Procure, Construct with Long Lead Items (EPC with LLI) similar to the EPC, but long lead items are procured by the project owner much earlier than the main EPC contractor is selected. The risk here is that if the engineering design requires material changes, it will be hard to accommodate it, as key materials and equipment have been bought. Yet, this concept significantly reduces the total lead time for the project and provides the project owner greater control over material and equipment manufacturer selection.
- Engineer, Procure and Construction Management (EPCM) is similar to the EPC, but actual construction is done by other parties contracted by project owners, usually managed by the EPCM contractor on behalf of the project owner. Although this is a relatively efficient delivery method and less costly to the project owner, this approach provides very little leverage for the project owner to make the EPCM contractor liable for project delays or budget overruns. This results in lower uncertainty risk to the EPCM contractor, hence lower prices to the project owner.
- Cost-reimbursable contract with a fixed fee is a contractual arrangement whereby all costs are reimbursed, with a pre-agreed fixed profit fee. This type of contract does not provide any incentives to the contractor to be more efficient with costs and will require a great deal of supervision from the project owner.
- Cost-reimbursable contract with a percentage fee is a contractual arrangement whereby all allowable costs are reimbursed, with a pre-agreed handling percentage of cost. This type of contract encourages wasteful behaviour, as the larger the cost basis the more the contractor earns a profit.
- Cost-reimbursable contract with an incentive fee is a contractual arrangement whereby all allowable costs are reimbursed and an incentive fee is paid to motivate the contractor to be more cost-efficient.
- Cost-reimbursable contract with an award fee is a contractual arrangement whereby all allowable costs are reimbursed with an additional fee based on contractor performance with clearly set criteria.
- Time & Material involves hourly or daily rates for manpower and reimbursement for materials purchased with handling fee. These contracts are used in smaller projects with very high uncertainty, thus providing lower overall cost to the project owner, as opposed to other forms of contracts.
- Alliance / Relationship Contracting is a contracting approach, also called pain-share / gain-share with commercial and physiological frameworks that drive the right behaviors, central to which is trust and no blame. This contracting approach is proved to be the most effective for all parties, but challenging to set up and develop, as it requires a big cultural change. Majority (more than 90%) of project alliances are delivered below the estimated cost and faster than planned. Under Alliance / Relationship contracting penalties and rewards are share amongst all parties, including the project owner.
Summary of contracting approaches and its attributes.
Key issues in project procurement
- EPC contracts are structured in a way that is best suited to the EPC contractor with regards to design, equipment manufacturers and construction approach. If the project owner insists on a larger involvement and requires more control over the project execution, equipment manufacturers and selection of subcontractors, other forms of contracts shall be used. Most common are EPCM and Cost Reimbursable. Yet, Alliancing represent the best combination of those factors.
- During the defect correction period, EPC contractor is liable for any defects, whereas EPCM contractor would only be liable for its own engineering work.
- For a number of services, the subcontractor and supplier base is limited; as such commercial offers given by subcontractors to the main EPC contractor are dependent on the like-hood of success of this particular EPC contractor. The major indicator is the number of transactions and its dynamics between EPC contractor and subcontractors.
- Major flaw of the Fixed Price approach is misalignment of objectives and inefficient risk allocation. Aligning objectives and ensuring that risks allocated in a way that puts the right party to manage that risk, proved to be the one of the key success factors in project delivery.
- Over the recent years, many Oil & Gas companies outsourced most of the project work to third parties. Hence the capability gap has grown significantly. A reverse trend is required to bring back those skills back to the organizations.