Weighing the contractual risks

23 December 2018
While majority of oil and gas projects are led through EPC contracts, the build contract model finds greater favour in the construction industry

Whether upstream or downstream, the vast majority of the GCC’s oil and gas sector projects are delivered through engineering, procurement and construction (EPC) contracts, although there have been a few notable exceptions.

State-upstream operator Kuwait Oil Company (KOC) is set to launch tenders for the construction of new gas production facilities under a build-operate-transfer (BOT) contract model. However, it remains an exception for the sector.

The major advantage of the EPC contract to the client over other approaches is that it provides a single point of responsibility. Within this, the lump-sum turnkey contract is the dominant procurement model in the GCC oil and gas market.

The model transfers the risk of cost overruns and benefits of any cost savings to the contractor, with only a limited ability to claim additional money due to variations in the work. Occasionally, clients will allow reimbursable contracts.

Under the BOT model, the developer provides the financing for the construction and operation of the facilities, in exchange for operating rights for a set period. Another option used in Kuwait’s upstream is to use Early Production Facilities (EPF) with the contractor operating the facilities for around five years to assess their viability before handing over to KOC.

These contracts, which are more common in the power and water sectors, have failed to gain traction in oil and gas however, with contractors unwilling to tie up their own capital resources in operating facilities.

Disadvantages of EPC

While there are advantages to using the EPC contract, there are also disadvantages, including higher prices as a result of contractors taking on almost all the construction risk. Contractors factor this transfer of risk into their price, building contingencies into the price for events that may never happen. Whether the increased price is worth paying is something clients have to bear in mind during negotiations.

Within the EPC contract, some clients are also looking for new ways to move their projects ahead. Traditionally, oil and gas projects are developed in three phases with conceptual and feasibility studies followed by a front-end engineering and design (feed) and then EPC. Studies are typically carried out in-house, with some consultant input to define the broad parameters of the scheme.

Since it comes with a relatively small cost compared with the final EPC contracts, and comes with no commitment to purchasing equipment, feed represents a stage-gate in the client’s decision-making process.

But it is a key process, without which the contractor would not be able to offer a lump-sum price. A question such as the amount of piping required for a new refinery build would only be answered during the feed process. The contractor still needs to carry out some engineering, using their own internal practices from years of experience.

One disadvantage of the feed and then EPC approach is that once the design is tendered, the EPC contractor needs to spend hundreds of thousands of dollars to develop their lump-sum cost estimate.

“What’s the point in spending all this money, especially for the large projects, and risk not getting it?” one source, who has worked on both sides of the fence, tells MEED. “In today’s environment, many contractors may not even bid. This is also disadvantageous for the client.”

The nature of the oil and gas sector is also very important. Upstream projects tend to need less equipment, and there are more established norms for cost estimates. However, the further downstream you go, the more complex the processing and more divergent the routes to get to this final product. Contractors are unwilling to risk offering a cost proposal without having done extensive engineering.

Adnoc is a rare example of clients’ shifting attitudes towards the process. The company is adopting a new strategy for dealing with contractors, as it looks to save money and time on a raft of major new oil and gas projects planned over the next few years, beginning with the planned $1bn development of the offshore Belbazem oil field.

The company has asked three shortlisted contractors to compete in the feed stage, with the winning proposal selected to carry out the EPC phase. “The two losing bidders will be paid a fee, although this is unlikely to cover their full costs,” says a source.

The feed competition, which comes at the client’s cost, allows the client to select the best technology based on his own specific selection criteria, as well as allowing him to pick and choose good practices that are not a part of a licensed offering.

Cost savings from the new strategy are not expected to be huge, but saving time will be critical. The time lost between completing a feed and sending out tender packages for EPC bids could easily amount to between six and 10 months.

The new strategy is expected to be deployed on a number of major new schemes next year, potentially saving millions of dollars by reducing the number of man-hours lost between the design and engineering phases of projects.

There are other permutations to the contracts used for projects, depending on the clients’ ultimate needs, and how it balances its schedule versus costs. Also factored in are the contractors’ appetite for risk, spending time and money on developing a lump-sum price only to see it awarded to a rival.

The new approach has clear advantages, in theory. It relies, however, on the client making timely decisions to make sure it does not risk losing any advantage it would have gained. The strategy requires a strong project management team from the client, most likely with support from a project management consultant.

“Clients always struggle to meet their own schedules. The reality is, this type of contract has never happened, for whatever reason, so changing this needs a brave decision,” one source says.

Lowest price wins

With increased competition for work, construction clients are happy to take advantage of the opportunity to drive prices down through the lowest-price-wins model for winning tenders. The tender price, however, does not represent the final outturn price. Contractors often end up recovering this price difference via legal battles. More so, lower tender prices can realistically only mean lowering standards and quality of the finished product. The industry needs to learn from its oil and gas counterparts that lower tender prices do not need to stem from cutting standards, but rather from efficient supply chain practices and innovative designs.

Public-private partnerships (PPP)

Using the private sector to deliver projects in partnership with the government takes away the initial capital expense required from the government, while also bringing in construction and operational expertise from a private sector consortium. The schemes typically involve a private sector consortium delivering a project and operating it for a period of time, during which it will derive revenues from the service it provides that compensate for the expense of building it.

PPP projects often include contracting firms as consortium members responsible for the delivery of the construction work. This is not only an investment opportunity for contractors, but also a way to deliver large-scale construction projects without being so reliant on clients for payments.

Transforming Construction Cover


This article is extracted from a report produced by MEED and Mashreq titled Transforming Construction: Lessons from Oil & Gas. Click here to download the report

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