Energy Sector Poised for Surge in New Capital Project Investment: Will the Industry Avoid a Repeat of the Cost Overruns that Have Impacted Projects

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Several Industry studies are pointing to a significant increase in capital expenditure in an environment where projects are already facing significant cost escalation and supply chain issues.?The International Energy Agency forecasts that annual energy investment will increase from pre-pandemic levels of just over $1.5 trillion to nearly $2 trillion in constant dollars between 2025 and 2030, with climate policy impacting the investment in energy sources more than the overall investment in energy.

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A recent article in Bloomberg (Sept. 23, 2022) highlighted the continuing challenges that the largest energy companies are having with cost overruns. The industry has suffered from these overruns for more than a decade and there is no evidence that this trend is improving. A recent AP-Networks survey of US Oil and Gas megaprojects (over $1 billion) indicates that almost all of them suffered major overruns and delays, even though they had governance and assurance processes in place. In addition, cost and schedule risk are likely to be exacerbated by current inflationary and supply chain pressures.

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The Bloomberg article also highlighted the role of overly optimistic assumptions and intentional under-estimating to greenlight projects as primary drivers of these overruns. Risk analysis techniques have not effectively captured or accounted for these overrun risks. The current environment makes the development of accurate estimates even more important. AP-Networks data shows a drop in construction labor productivity and high-cost escalation over the last three years.

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Escalation may start to cool but improving productivity will be difficult given the shortages in the labor market. Pre-pandemic, labor productivity had stagnated for over a decade.?A pre-pandemic article by The Economist, “The Construction Industry, Least Improved,” August 18, 2017, concluded that some construction industry practices and structural problems increase costs for buyers but hamper investment in improving productivity. ?Moreover, AP-Networks’ analysis of projects from the last decade found declining labor productivity for heavy revamp projects.

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Can Benchmarking Help?

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Industry has been benchmarking capital project performance to support improvement initiatives and to understand cost risk for over three decades. The cost benchmarks ideally compare the planned project estimate with industry norms and can provide a check on the realism of the current target and whether it lies outside the typical industry historical range.?Still project cost and schedule predictability, and productivity have not improved.??A common traditional approach to benchmarking capital cost is the Lang Factor Analysis.?The Lang Factor, which is the ratio of the total project cost to total equipment cost, is an estimating tool developed seven decades ago (Lang, H.J., Chemical Engineering (1947)).?Lang Factors can be found for various types of plants (see Table 1).?Project teams and estimators compare these Lang factors, after making adjustments for escalation, location, and size, to their project estimates and actual costs to benchmark performance.?In theory, higher Lang Factors indicate that a project was more expensive; lower Lang Factors indicate competitive results, or, in the case of an estimate, cost risks that may result in an overrun.

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Typically Used Lang Factors

Process Type

Range of Lang Typical Lang Factors

Solid Process Plant

3.10 – 3.89

Solid-Fluid Process Plant

3.63 – 5.04

Fluid Process Plant

4.47 – 6.21

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Many of the traditional cost benchmarking methods relying on some variant of the Lang Factor work on the assumption that equipment costs fully describe a project’s scope and can be used to factor up to total capital costs. Statistics show that in general as more equipment is installed total costs increase, however, there is a large degree of variability in the equipment to total cost relationship. Indeed, the variability is more than 100 percent.?

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As a result, using traditionally based benchmarking, such as the Lang Factor to improve performance is challenging.?Too often benchmark results are not understandable and the results do not provide enough specificity to help project teams improve performance and deliver successful outcomes.?Clearly equipment costs alone do not fully explain total project costs. Particularly for revamp and brownfield projects, the Lang Factor approach does not provide a reliable method to benchmark costs.

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A Better Approach: Advanced Benchmarking Methodology (ABM)

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At AP-Networks, we developed the Advanced Benchmarking Methodology (ABM) to help our clients better understand the reliability of their estimates. ABM helps companies understand how much risk they are assuming when embarking on a major capital project.?Is the estimate too aggressive and adding too much risk? Or is the estimate conservative and padded leading to spending more than needed.

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An important foundation of benchmarking Industry projects is a database of contemporary project characteristics, practices, and outcomes.?AP-Networks has a database of several thousand capital projects covering the refining, chemicals, energy, mid-stream, and power generation industries.?More than 40 chemical and refining companies are represented in the database.?Project costs range from $5 million to more than $10 billion.?Revamp, debottleneck, brownfield, and greenfield projects are all represented.

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ABM provides more specific, actionable benchmarks than traditional project cost benchmarking.?Our research shows that how much a project costs depends primarily on two things: the amount and kinds of materials installed and the productivity of the indirect and direct labor doing the work. AP-Networks’ ABM uses the amount of equipment, piping, steel, concrete, electrical and instrumentation being installed to benchmark the required amount and productivity of indirect and direct labor. This scope-based approach offers distinct advantages.

·????????Fully accounts for the project’s scope by considering the mix of material being installed

·????????Focuses on indirect and direct labor thereby providing actionable insights to management.

·????????Transparent comparison of your project to other similar scope projects.

·????????Uses advanced statistical methods to improve the accuracy of benchmarks.

·????????Can be applied to a wide variety of projects.

ABM measures the construction labor productivity for specific disciplines and provides benchmarks for project indirects.?This information helps the project team understand specific project risk areas, and or project cost relative to peers. Importantly, the detailed breakdowns?provides actionable data to the project team which may be under pressure to reduce cots or explain how the estimate compares to peer projects in industry.

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Conclusions

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Setting the right targets is critical to achieving project success in the current highly uncertain project environment. ABM provides competitive insights and identifies the levers to improve a project’s competitive position.?ABM provides credible and reliable project cost and schedule benchmarks that fully address project scope, and account for piping and mix of other materials.?The ABM covers a wide range of projects from greenfield to revamp projects, which are particularly problematic for traditional cost ratio analyses.?The industry benchmarks are transparent because they are related directly to the project scope and quantities.?The transparency of the benchmarks enables identifying risk areas and taking action to improve performance.

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Learn more about ABM at https://www.ap-networks.com/benchmarking-ai/

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