Part 2 - Why our way to develop projects fails to minimize CAPEX?

Minimization of an Oil & Gas facility CAPEX comes from 2 areas: design optimisation and minimisation of equipment/materials and works costs. Cost minimisation in these 2 areas takes place at 2 different stages of the project development: FEED for the former and EPC for the latter.

For instance, at FEED stage the types of isolation valves shown on the P&IDs are reviewed to identify where ball valves are really needed vs much less expensive gate valves.

At EPC stage, once the supplier of the ball valves informed that the owner specification requirement for ball valves to be trunnion rather than floating types significantly impacts costs, a review of such requirement can be done and a deviation proposed, e.g., to use floating ball valves up to 3”.

In the first part of this Article, I explained why the way we currently perform FEED does not allow to minimize costs by optimizing the design.

In this second part I will explain why the current contractual set-up of the EPC also fails to minimize costs of equipment/materials and works.

Let’s start with a success story: while contracting a FEED, as a LS, the Client made the contractor aware that the current project cost estimate was 40% above budget and that the project would go ahead be executed if the FEED, that included a +/-10% cost estimate, would find ways to bring the project within budget. The contractor had interest in the project proceeding as it had a good chance to execute it. We strived, challenged the design, and, jointly with the owner, reviewed and optimized each design criteria, challenged onerous requirements of the common engineering practices or owner specs and proposed alternatives. We managed to get into the budget. Note that the project functional requirements and plant performance were not affected by the cost savings.

Most of the cost savings we made could be applied on every project. I am convinced that there is considerable room for cost savings by applying such approach systematically. To this end one needs to build a check list of what is to be reviewed (design criteria, equipment type, codes & standards, etc.) together with ready technically justified proposals of cost effective solutions.

Let’s now tackle the second area of cost savings, that linked to equipment/materials and work. These cost reductions come from justified deviations from the owner specifications. There is much room for cost reductions as owner specifications have become very numerous and onerous. They were developed during the years when cost was no issue.

Today’s contractual set-up leaves no room for any deviations from these very costly referentials.

First of all, at EPC tender stage, the EPC tender has no time to assess the full cost impact of these specifications, let alone propose alternatives.

Indeed, assessing the cost impacts of the specifications on equipment/materials and works requires review of the specifications by vendors and sub-contractors. Such reviews cannot take place during the tendering phase due to the effort required and lack of time.

Then, once the EPC contract is placed as a LSTK, there is no room to discuss any deviations from these specifications either. The Owner and contractor agreed a fixed price on the basis of the owner specs. Why would the owner relax the requirements of its specs?

We must find a set-up that aligns the interests of the owner and the contractor towards cost reduction.

Let’s look at the various forms of EPC contracting:

? LSTK is a no go, as explained above.

? Cost plus, where a fixed mark-up of 5 /7.5 /10% of the Project cost is reimbursed to the contractor defeats the purpose, as the higher the project costs the more money the contractor makes,

? EPCM, where the contractor is paid a fixed amount for services, even with an incentive linked to a final price, leaves the bulk of the cost, quality, and schedule risk with the Owner. Orders/sub-contracts are indeed placed by the Owner, the contractor acting as agent. The scheme does not incentivize the contractor to work hard on cost savings. It neither offers the Client a price certainty.

? The Open book approach allows Owner and contractor to jointly and progressively decide about the design, equipment, vendors, materials, construction contractors etc. In such a scheme the contractor discloses the costs to the Owner. These costs are progressively firmed up as the project progresses, orders are placed etc. The owner is in a position to influence the costs by, e.g., allowing some deviations from its specs, vendors list etc. It may also have the option to convert a portion of the job, such as main equipment supply, bulk materials supply and construction, to lump sums, at different times of the project. Purchase orders and sub-contracts are placed by the contractor who therefore bears the cost, schedule and quality risk. The key aspect to make such a scheme provide an incentive to contractor to minimize costs is the type of compensation it receives. A % fee on the value of the converted part (main equipment, bulk, construction), which is the usual practice, defeats the purpose. It is the usual practice as, sensibly, the final price that can be expected of a purchase order or sub-contract, allowing for inevitable extra costs, is some percentage of the initial PO/sub-contract value. However the % fee usually applied to the value of the converted part does not only include these cost adders but also Contractor's profit. It would be better to separate the two in order not to create inflation of PO/sub-contract costs. Contractor's profit could be a fixed amount with a gain/pain incentive on the basis of final project cost versus target.

Only this last scheme makes the owner aware of the cost impacts of the requirements of its specifications. It gives the owner the opportunity to re-assess these requirements and agree deviations which significantly reduce the final project cost.

The trick to implement the above scheme, one may argue, is to agree the target final project cost. The contractor would naturally want to set a high target and the Owner a low one.

One solution would be to have EPC bidders compete and provide, in their bid, a proposed target total cost.

Let’s sum-up this scheme:

1)   The owner issues an inquiry for the EPC under an open book convertible approach whereby contractor shall give a cost breakdown and a target total cost.

2)   Contractor A quotes a target EPC cost of 100 broken down as follows: 10 for Engineering & Services, 30 for Procurement of Equipment, 20 for bulk procurement, 30 for Construction, 10 for overheads and profit.

3)   The contract is set-up so that contractor receives a fixed 20M for Engineering & Services, overheads and profit. Contractor gets an additional 1M for every 5M saved over the target cost and a penalty of 1M for every 5M spent over the target cost.

Note that, just in the same way as for cost, a schedule incentive could be put in place. A schedule incentive is already there anyway, as being paid a fixed amount the contractor aims at the shortest execution to demobilize sooner and spend less hours.

To better understand how the above scheme works, let us execute it step by step:

1)   At the start, the open book estimate of the total cost is 20 (contractor fee - fixed) + 30 (Equipment) + 20 (bulk) + 30 (Construction).

2)   The design progresses,

3)   The EPC contractor starts by specifying and inquiring the equipment. Equipment bids from vendors are analysed, clarifications are held to identify onerous requirements coming from owner specs. The owner decides not to apply its specs to the compressor package, which yields a 30% cost savings and 3 month shorter delivery. Thanks to such deviations the Equipment cost comes down to 20.

4)   Conversion of Equipment supply is done, at a price of 20+5% = 21. Equipment purchase orders are placed by contractor.

5)   The design progresses to sufficient details, e.g., IFC P&IDs and 60% 3D model completion. Bulk BOQs are up-dated and inquiries issued. The owner allowed orders to be placed to be a selected supplier in China. This yield 50% cheaper valves. This cost saving reflects in the bulk supply price which comes down to 15.

6)   Conversion of bulk supply is done, at a price of 15+5%=15.75.

7)   The design progresses further up to 90% 3D model completion. Construction BOQs are up-dated and priced. Contractor and owner identified the big impact of application of passive fire protection on the construction schedule. They jointly and precisely review the PFP requirements and are able to cut it by half (see note at the bottom of the post). This allows to shorten the construction duration and lower its cost down to 28.

8)   Conversion of construction is done, at a price of 28+10%=30.8

9)   The EPC contract is now a lump sum, of a total amount of 20+21+15.75+30.8 = 87.6.

10) As the final price is 12.4 below target, the contractor gets an additional 2.5.

11) Finally, the cost for the Client is 90, i.e., 10% lower than target and the contractor makes 2.5, i.e., 12% additional profit.

Appealing scheme, isn’t? The most appealing is that the owner has control over the costs and can therefore influence them.

I know that such schemes are nothing new. In the current low oil price context they could have become the norm. They are not. As far as I know, they are currently implemented on special cases only, i.e., prototype/frontier jobs.

What could be the reasons?

Would that be that, by departing from its specifications, the owner gets a sub-standard facility?

My experience is that a very large number of deviations from owner specifications result in no loss of quality/functionality at all. For instance, applying the project paint specification to all items is not justified: the vendors of valves, for instance, have their own paint systems. Out of these systems, one is most likely to be suitable for the Plant environment. Imposing the application of the project paint system not only results in extra cost but also lower quality, as the imposed painting process is not the usual one that the manufacturer masters.

Would the Open Book scheme be too demanding on the Client side? It might be so, as:

? The owner must be able to assess proposed deviations to its technical referential. Has he still got those skills?

? The owner must be in a position to check the conversion prices, e.g., the BOQs. Is the owner able to do that?

Could this be the real blocker? If so, we owe to our industry to find solutions, which should be within easy reach.

Your comments are, as usual, very much welcome and valued.

Note: an IOC reviewed the extent of the PFP, a major headache in construction, on similar FPSOs designed and built by different contractors. The quantities of PFP varied from 1 to 3, without reason.