We're Not in Kansas: EPIC Project Risks Are Real
We have an industry problem that's getting bigger and getting worse. Others may address the topic next week or next month, but someone needs to talk about it now. The problem? The burden of risk, specifically in EPIC projects, liquidated damages, insurance and the labor pool.
Owner/operators are demanding that Engineering, Procurement, Installation and Commissioning (EPIC) contractors shoulder project risk, an unreasonable mandate in light of world and industry volatility.
Producers in international areas have adopted a sometimes myopic view, resulting in polarization between oil and gas producers and the service industry. I realize, as you do, that methods of operation differ from place to place and continent to continent.
However, a universal standard for risk assumption must be agreed upon among the owner/operator/producers of the energy sector and the companies that compose the oil and gas service industry. We need to work together to devise a solution that is to all our benefits. As it stands now, the risks far outweigh the reward.
At Global Industries, we began our international expansion in 1995 in West Africa, in 1996 in Mexico and Asia Pacific, and then in the Middle East in 1997. We entered those markets as an installation contractor or subcontractor. Later, as the business climate changed in the late '90s, we begin accepting EPIC contracts.
Our EPIC contract experience, especially in international areas, has not been what we hoped or expected.
As opposed to the Gulf of Mexico, where contracts are segmented by specialty, in some international areas there are relatively small contractor bases and, therefore, clients tend to bundle project packages to include fabrication, transportation, installation and commissioning.
Frequently, the engineering component is added, making the contract EPIC in nature. In addition, some countries are encouraging or requiring local content to build their in-country capabilities. Unfortunately, this often requires the use of contractors or subcontractors with questionable capabilities or the use of subcontractors that are not familiar with international operator requirements for project management, quality, safety and productivity.
This is the situation Global encountered on a recent EPIC project bid on an all-international content contract. We were required to submit a proposal maximizing local content. Global was awarded the contract based on local content and required to use in-country fabrication of the pipeline coating and jacket.
The pipeline coating was successfully performed; however, the jacket fabrication portion was not as successful. We discovered the project schedule was overly optimistic and that we should have exhibited greater due diligence in the selection of subcontractors.
Although we had worked previously with the subcontractor we chose on smaller structures, the company lacked some of the equipment resources, craft-level supervision and project management necessary for successful execution of this larger structure.
As local content requirements expand, we are finding there are not enough qualified local companies able to meet the demand. This is becoming worse, particularly where there are engineering studies and proposed projects to eliminate the flaring of natural gas.
Moreover, there are major projects about to be awarded requiring maximization of local content and, therefore, a high demand for local labor with a low supply level.
Unfortunately, the example above is not unique. In another EPIC project that did not meet our execution or financial expectations, resources required to manage much of the engineering and upfront planning during the initial stages of the project were underestimated.
We also discovered a lack of available experienced personnel for the project management team, a problem we believe is industry-wide. Finally, we experienced work slippages in engineering and, as a result, fabrication. Together, these factors led to poor project execution and profitability.
Liquidated Damages Problem
This contract also demonstrated a real-world problem with liquidated damages imposed by our clients. For example, if there is an engineering delay on a $50 million contract, the contractor or consortium may be exposed to 10 percent of the contract value.
An engineering group with $1 million in contract value obviously will not take a $5 million risk for this contract. Therefore, the monetary risk for any engineering delay has been borne by the prime contractor or consortium as a percentage of contract value.
We are also discovering many operators are taking a harder line and putting more risk assumption on the contractors, especially in the wake of the consolidation of the major oil companies.
Many EPIC contractors are accepting contracts with liquidated damages, but some believe the risks are too great. Global is selective as to which projects we will accept as a prime contractor and which we prefer to participate in as a subcontractor.
Quite often, we will only participate in a bid that minimizes the portions of the work that are to be done in-country, such as pipe coating, fabrication of certain components, or possibly a portion of the engineering.
Global's contract decisions, therefore, are based on the complexity of the project, size of the project, schedule, contractual terms, operator and location.
Currently, we are not the prime contractor on most of the EPIC jobs we have outstanding. Instead, we are a supporting subcontractor and installation subcontractor, resulting in less exposure and less involvement.
In some areas, the EPIC market represents approximately 50 percent of the total offshore installation market. When considering contracts for this type of work, the percentage of installation versus the fabrication and engineering portions of the contract comes into play.
Projects with greater installation values as well as field development-type projects with pipeline and small structures represent good prospects for Global.
Consortiums are another alternative where each member absorbs a portion of the project risk, rather than the contractor shouldering the entire burden of risk.
The experiences related above illustrate some of the problems oil and gas service companies routinely face. As these difficulties increase, client-mandated third-party engineering and/or fabrication may become an uncontrollable situation if not managed and coordinated properly with the necessary level of interface.
Outsourcing could possibly result in poor performance and a less-than-hoped-for bottom line. Problems at the front end can also snowball and preclude a successful outcome.
However, as engineering and fabrication subcontractors grow in experience with large projects and gain sophistication in working with large companies, many of the situations being encountered currently may disappear.
Another critical issue that we have encountered is that qualified and experienced project management and project field personnel are in limited supply, and those available are aging. As I said before, this is a worldwide quandary in which we find ourselves.
The increasing requirements to use indigenous employees may be necessary if foreign countries ever hope to employ the otherwise unemployable. However, the number of indigenous employees qualified is limited at the present, especially considering the limited technical and engineering education available to the potential labor pool in these international areas.
What effects do third-party sourcing, subcontractor lack of experience and limited human resources have on companies in the oil and gas service industry? Plenty, and they aren't pretty.
First, earnings and stock prices are negatively affected. Client demands for international participation are well and good, but not if that participation generates negative earnings.
Second, liquidated damages, part of almost every international EPIC contract, are passed on to subcontractors as a way to mitigate risk. However, they are passed on as a percentage of the subcontractor scope of the project, while the prime contractor risk remains as a percentage of the total contract.
The contractor is already facing double penalties from potential loss of performance and loss of future contracts due to project slippage. The contractor does not need to be penalized further from the added loss resulting from liquidated damages.
Third, all of us are encountering new insurance requirements that can only be described as onerous. Insurers, and there are 85 percent fewer of them than there were three years ago, have increased their rates. Exclusions have increased. Deductibles have increased. Paperwork requirements have escalated. They want detailed information about the scope of work. They want job schedules. They want to limit their coverage.
Many companies have opted to self-insure or, worse, have elected not to insure, giving greater risk exposure to the contractor.
Fourth, inspection requirements are comprehensive, circumstantial and critical. Many project inspectors are returning to the workforce after a less than financially comfortable retirement to concentrate on the minutiae, justify their existences and protect their jobs.
The work these people do and their attitudes are important both to the client and the contractor. Ultimately, increased project selectivity is encouraged.
A number of our competitors have determined that the risks are too great to pursue EPIC projects vigorously. Halliburton, Stolt, McDermott and ABB come to mind immediately.
In October 2002, Niels G. Stolt-Nielsen, CEO of Stolt Offshore S.A., said, "Our industry is suffering as a consequence of customers requiring contractors to assume increased risks when we take on larger and more complex projects. We will, of course, continue to take on EPIC contracts as the market demands but we will not accept contractually onerous terms, which we have in the past. Our preference is to contract high-risk projects on a cost-plus basis or working as part of a consortium in order to spread risk and project profitability."
His thoughts echo my own. McDermott International was specific in their 8-K dated June 26, 2002: "We continue to be extremely disappointed in JRM's performance on the Medusa project and have conducted an extensive review of the causes of these overruns, available remedies for these problems, and their financial impact. These cost overruns relate primarily to additional costs arising from design delays and changes on this first-of-a-kind project, productivity losses arising from these design delays and changes, productivity losses from the start-up of previously dormant fabrication yards, and schedule delays resulting from these factors."
In an October 2002 press release, McDermott International chairman and CEO Bruce Wilkinson stated, "we will not accept EPIC contracts that place a disproportionate amount of risk on the contractor without appropriate monetary incentives."
Some companies may take on the increased risks of which Stolt-Nielsen and Wilkinson were speaking. We are more selective and will not participate in contracts that are destined for low compensation and high risk.
All publicly held companies have the same responsibilities as our clients: to generate profits and share price appreciation. In today's world of increased commodity prices, contractors are facing a disproportionate award distribution, minimal margins and difficult contract terms. As a result, many are experiencing a serious decline in stock value and shareholder confidence.
Although marginal profitability may satisfy lump-sum EPIC contracting for some companies, it dictates cost-plus or time-and-material for others. In addition, there is a third group of companies that have the engineering and fabrication resources but still do not want to take the risks associated with a particular project.
As a result, there is mounting pressure on operators and producers to accept EPIC projects on a T&M basis, as fewer and fewer contractors are willing to accept lump-sum contracts.
Selectivity also implies a complete knowledge and full understanding of the geography, demographics and culture of the region where the project is to be executed. Development of in-country capabilities and infrastructure is a process that needs to be encouraged, but with the understanding that it is going to take time.
We need to recognize that as an industry, we cant have it all, nor can our clients. Our suggestion is a reasonable risk/reward matrix with a profitable outcome for both.
William J. Dore, chairman and chief executive officer of Global Industries, Ltd., entered the offshore construction business in 1969 as a marketing representative for Global Divers & Contractors, Inc., a provider of diving services for the oil and gas industry. In 1973, at the age of 30, he purchased Global Divers and began diversifying its services.
Under his leadership, Global capitalized upon a series of major acquisitions including Sea-Con Services, Inc. in 1987, Santa Fe Offshore Construction Company in 1990, Teledyne Movable Offshore in 1992, the Red Adair Company in 1993, selected assets and operational bases of SubSea International in 1997, and diving assets and related equipment of Oceaneering International in 2000.
Through its subsidiary companies and construction operations, Global Industries provides offshore construction, engineering, and support services including pipeline construction, platform installation and removal, and diving services to the oil and gas industry in the Gulf of Mexico, West Africa, Asia Pacific, Middle East/India, South America and Mexico's Bay of Campeche.