BETTER CONTRACTING IN OIL AND GAS MAJOR PROJECTS

BETTER CONTRACTING IN OIL AND GAS MAJOR PROJECTS December 2008 Management consulting at Charles River Associates

With the recent headline-grabbing rise in oil prices and the consequent increase in major project activities, oil companies and their suppliers need to design and implement contracts to build new production capacity quickly. Operators, be they international oil companies (IOCs) or national oil companies (NOCs), must deliver complex and technically challenging projects on time, while guaranteeing quality and controlling costs. Meanwhile, suppliers and contractors are seeking to maximise the value of the goods and services they sell while keeping their risks as low as possible. Although their interests sometimes diverge, operators and suppliers share the need to improve the effectiveness and clarity of their contracting approaches. This paper presents the different perspectives of IOCs, NOCs and suppliers, and recommends eight levers that will enable all of them to significantly improve project contracting IOC perspective After many years of over-capacity in their project supply chains, IOCs now face restricted supplies of goods, services and people. This has led to high levels of inflation in everything from engineering services through to raw materials. More seriously, there is a shortage of capacity to get major projects built at all. Securing supply in a tight supplier market IOCs became used to an over-supplied market in the latter half of the 1990s, but the resulting low margins for major suppliers and contractors led to reduced investment in building their businesses. This left them under-sized to meet demand when market conditions improved. Supply has become even tighter as high oil prices have led to a wave of mega oil and gas projects, coupled with a boom in civil infrastructure projects in oil producing countries. At the same time, China and India are executing huge industrialization programmes. These projects are tying up the resources of the larger multinational service firms especially those that have local joint venture partners leaving less traditional capacity available to IOCs. Avoiding detrimental local content stipulations As oil prices have climbed, NOCs and major resource holders (MRHs) have increased their market power over the IOCs. They have used this power to demand that IOCs both deliver their projects on time and on budget, and invest in local economic development. To promote economic development, MRHs typically demand the use of local suppliers for the supply of goods, services and materials. All too often, this can turn into a requirement to only use local suppliers, or to develop sub-standard local suppliers. Local content requirements can prevent IOCs from using global suppliers who offer lower costs better quality through contracts for multiple projects. This puts the IOCs into an impossible position, as they can meet the most demanding local content requirements or deliver on time and budget, but they cannot do both. Need for stable investment conditions Another consequence of this increased market power is that the IOCs are left with a riskier set of major projects. MRHs are executing the simplest projects without IOC support. IOCs are being left with the technically more challenging and riskier projects, such as ultra-deep water, viscous oil, tight or sour gas, and arctic projects. To deliver such projects profitably, IOCs argue that they need predictable fiscal terms and long-term access to the best suppliers. IOCs believe that such stable investment conditions and long-term relationships will help them train and develop a better cadre of international and local contractors and suppliers that will improve project execution and lower project risks across multiple, sequential projects. This approach also allows IOCs to develop their own expertise and become more effective over time. 2

IOC needs Faced with these market conditions, we have seen that IOCs are looking for: Access to high quality capabilities, goods and materials Significant investments by major suppliers and contractors to increase their own capabilities and improve their supply chains Sequential projects that create learning curve opportunities They see the main enablers of this to be: Predictable, stable investment conditions Long-term contracts to develop multiple projects in a basin, province or consistent operating environment And the main threats to be from: Competition for suppliers from larger-scale, more attractive contracts, typically with the larger NOCs Detrimental local content stipulations that drive up costs and reduce quality of inputs Over-reliance on too few core suppliers Government and NOC perspective All NOCs share a common goal: to maximise the value from their national resources. However, each has a different approach, depending on its relationship with the government, its maturity and the portfolio of resources that it manages. When it comes to contracting major projects, some NOCs are operators, while others have a checks and balances role as a non-operator. Whatever their role, NOCs need to ensure that capital investment is managed as prudently as possible and in line with government economic policy. We have found that NOCs typically focus on three major aspects of contracting strategy: maximizing local content, managing costs and minimising risk exposure. Maximising local content Governments desire to promote local content is understandable each hydrocarbon rich country wants to develop its secondary economy as much as possible. To implement this, many NOCs have developed a sophisticated approach to applying local content conditions in their contracting strategies for major projects. The traditional argument that local companies lack necessary skills and technology is no longer valid in most regions. It is widely accepted today that every major project can improve on the local content achieved previously. NOC managers tell us that they believe this incremental approach, used widely in projects in Asia, West Africa and the Middle East, has been very successful. The greatest challenge to achieving increased local content is gaps in local supply chains. An NOC needs to ensure that local supply chains provide both the long-term investment in sustainable skills, capabilities and infrastructure, while meeting the near-term requirements of specific projects, but they find this a difficult balance to achieve. Managing costs In our work with NOCs, we have seen that many NOC managers believe that cost inflation is not entirely due to inflation in commodities and raw inputs. They believe that much of the increase comes from higher supplier margins and inadequate contracting terms. Therefore, they want to create better capabilities to manage these cost increases. This means improving the skills of their procurement functions and gaining experience with strategic sourcing, supplier management and contract management. They also believe that badly designed oil and gas fiscal terms can fail to prevent excessive spending being passed on to the government. NOCs and governments are very keen to improve their ability to prevent this. 3

Minimising risk exposure NOCs need to minimise the risk of project failures.to do this, they have developed rigid control processes. However, they are now facing pressure to approve and execute more projects to take advantage of high oil and gas prices. This has led to contradictions between their approach to procurement and their strategic goals, and has also increased strains with their project partners. Government and NOC needs We have seen that host governments and NOCs are looking for: Maximum economic contribution by a major project to the local economy Minimum costs and risks for the host government and NOC They see the main enablers of this to be: High local content targets Greater influence on procurement decisions, supplier management and contract management Greater capabilities to design and apply fiscal terms appropriately And the main threats to be from: Overly short-term focused investment in local content Non-adherence to procurement procedures by IOCs Improper use of fiscal terms by IOCs, to pass on costs to governments Major supplier perspective After many years of low margins and slow growth, major suppliers are enjoying full order books and higher profitability. However, suppliers are finding it difficult to take full advantage of this increased demand. First, they are struggling to recruit new staff, as the market is short supplied, and training, especially for new engineers and technicians, is a relatively long process. They are also losing staff, as competitors, faced with the same staff shortages, push up wages. This is causing their knowledge base and experience to become diluted, making it harder to work on multiple large contracts. Second, they are facing new competitors: subcontractors moving upstream along the value chain and suppliers from developing economies taking advantage of growing knowledge and skills, lower cost bases and increasing globalisation. Third, they are facing high inflation in their own supply chains, because of raw material price inflation and shortages of manufacturing capacity. To overcome these challenges, suppliers need contracts that provide both financial returns and the opportunities to sustain and grow their businesses. Need for longer term contracts to enable investment and develop staff Suppliers always struggle to make investments that are longer term than their order books. Senior managers from major suppliers tell us that they find it difficult to make major investment decisions, and are concerned that the cycle may turn down again. Hence, they are keen to enter into longer term contracts that reduce their uncertainties and allow them to invest in people and capacity building. Doing so would also keep their sales costs down, by reducing bidding and marketing costs, which can be very high. Achieving fair returns for demanding projects In a high-demand environment, suppliers are less willing to take on the risks of large and complex projects, and demand better contracting terms. They wish to ensure that each project delivers a target return level, and so seek to mitigate risks that could lower returns. Suppliers also want NOCs to agree to the same contracting terms that they expect from IOCs, with prompt payments and proper dispute resolution processes. Some suppliers are also keen to enter into contracts that give them the potential of highe returns, through performance-related incentives, 4

but are unwilling to put their base profit margins at risk through reciprocal penalty arrangements. But Need for opportunities to grow in new sectors and markets Stakeholders and shareholders in major suppliers demand growth. To grow, they need business in new markets and sectors. They therefore seek opportunities to diversify into new geographic markets, while limiting their investments and exposure until they have contracts in place. Suppliers are looking for customers to help them grow by offering contracts for new, non-traditional services. This could benefit operators by creating more choice and competition, although it could also change contracting models, as new suppliers bring their own practices. An alternative growth model for suppliers is to acquire existing firms. This can benefit IOCs and NOCs by offering more integrated service providers, but it can also reduce competition and choice. Major supplier needs We have seen that major suppliers are looking for: Higher margins Growth opportunities Greater predictability around future business They see the main enablers of this to be: Longer term contracts to reduce sales costs and enable (re)investment Fair contract terms, with upside potential Opportunities to get into new markets and sectors And the main threats to be from: Reluctance for IOCs and NOCs to make commitments Over dependency on NOCs Better performers find ways to resolve differences As our discussions have shown, IOCs, NOCs and suppliers have very different interests and perspectives. Despite these obstacles, they sometimes find ways to work together effectively. This happens when the players create the right contracting environment for their major projects to succeed. We believe there are eight main levers at the parties disposal, and that these levers will work for any set of IOCs, NOCs and suppliers. Using these levers will ensure the right contracting strategy is implemented in the best way possible. Schedule aligned with marketplace Right people Local content strategy aligned with government Structured Supply chains Eight levers for better contracting in major oil and gas projects Contractor continuity Share simple incentives Cost visibility Fair risk allocation model 1. Structure the supply chains properly Projects work best when the players design supply chains to allow direct and consistent communication. To do this, designers must take account of both the criticality of individual suppliers and the relationships among project partners. A common pitfall is for an IOC or NOC to push for a single top-tier supplier structure (e.g. a single EPC contract) in order to reduce project management interfaces, making it impossible to deal directly with the long-lead component suppliers that are most critical to achieving a successful project schedule. Another common 5

mistake is for NOCs to set up alternative and multiple communications channels with various suppliers, rather than creating a common structure and governance model with all the equity partners. Tier 1 suppliers Long lead item supplies Technology suppliers Operator + Partners Long lead item supplies Critical equipment suppliers 3. Select a risk allocation model that genuinely reflects risk capacity The best way to ensure that risks do not lead to lengthy project delays or cost over-runs is to select the right risk allocation model. Risks eventually fall back onto those best placed to manage them, but it can be a painful and protracted process if risk is incorrectly assigned in the first place. A common pitfall is for NOCs to insist on suppliers taking all the cost and schedule risk (including those risks outside of their control) because the NOC fears giving suppliers too much licence to inappropriately increase costs and or delay project schedules. To correctly assign risk, all the main parties must be involved in the upfront risk analysis. This may cause friction and force some differences of opinions into the open, but it is far preferable to do this early on rather than when things begin to go wrong. Project cost Tier 2 suppliers 2. Build incentives that drive each party to a common goal It is difficult to structure and apply incentives in a rapidly changing economic environment, as there are lots of conflicting interests. For an IOC operator, the biggest risk to value is production start-up delays, especially if the concession timeframe is short. For an NOC, the biggest risk is higher than expected project costs, which reduce early oil available for sales. For a major contractor, it is overruns that impair earnings and tie up critical resources needed for other projects. It is therefore important to align all parties around one overall meaningful goal, such as on-schedule delivery or a target cost. To do this, all parties need to review and compare their project objectives at the beginning of the project. Once a shared goal is established, the parties can then develop specific incentives based on the influence of each party on achieving that shared single goal. Lowest Project cost 0% 100% Contractual transfer of risks to suppliers 4. Strive for cost visibility at each level in the supply chain In a high inflation environment, all parties should strive to make their costs as visible as possible. This builds trust between them and creates a shared ownership of total project costs, which in turn promotes the collective management of unexpected cost changes. It is more challenging to award contracts where costs are broken down and visible than it is to award contracts on a sealed-bid fixed price basis. However, this extra complexity in the award process should not be used as a reason for advocating a black-box. 6

Cost visibility Operator s ability to manage variances in costs 5. Build in the opportunity for contractor continuity through follow-on projects When IOCs and NOCs structure contracts in a way that offers the prospect of subsequent contracts, such as sequential projects, this creates a powerful incentive for improving performance, committing high quality people and making local investments. It also allows for all parties, not just suppliers, to apply the lessons learnt from the previous contracts and to invest in staff training and knowledge. This approach results in progressively lower costs, relative to a brand new project. In the current environment, the benefits of having experienced teams outweigh the risks of an incumbent supplier giving poorer performance and above market prices, as long as those risks are mitigated through a proper supplier management process. Single large project Project 1 Discrete follow-on projects Project 1a Project 1b Project 1c Single lump sum price Open-book Costs by Tier `` Suppliers Open-book Costs by Tier 1 and 2 Suppliers` Duration Duration 6. Ensure that project has a local content strategy aligned with host government objectives Local content goals for a project should be aligned with the economic development priorities of the host government. If these are not clear, then the IOC or NOC should ensure that work is done to clarify these up front. This makes it possible to agree an acceptable balance of short- and longterm local content goals. A common pitfall is for all parties to agree local content goals but not a feasible governance structure to monitor the delivery of local content during project execution. To mitigate this risk, all parties should jointly manage the implementation of the local content strategy to ensure that as the project is executed, the best decisions are made in-line with government goals. This approach prevents an excessive focus on crude measures, such as the percentage of purchasing from local suppliers at any given moment, and the use of such measures to force major renegotiations or project changes. Government economic priorities Country local content strategy 7. Match the contracting and procurement schedule to the supplier marketplace Specific local content goals for contracts In the current environment, contracting processes, approval processes and award processes should be designed to fit with the response times of the marketplace. A common pitfall is for an NOC to expect suppliers to take all the cost and schedule risk while waiting for decisions, either because the NOC adheres to overly long internal processes, or is not aware of the risks from delays. However, today s best suppliers will not tolerate overly long or complex processes that make sense only when the market is suffering from spare capacity. All project partners should work together to understand and explicitly address these response times before setting down contracting processes and timeline. 7

Continues activities Award Start project execution Operator Market/ Suppliers Prepare 1 Assess Decide Bid Create team Finalise contract Early work Project Schedule 8. Use and keep the right people In a tight market with rising demand for projects, IOCs, NOCs and suppliers are experiencing growing staff turnover. This has diluted their base of skills and experience (especially among IOCs and suppliers). But it is crucial for project delivery to allocate the best people, committing them for the duration of the project. Contract terms often fail to require this, but we believe that such conditions are crucial. After all, it is experienced people who make the difference between project success or failure. Conclusion Today s environment is creating severe pressures on IOCs, NOCs and suppliers. Although each party has different interests and perspectives, we believe that they can work together effectively making project success more likely. The eight recommendations that we present in this paper are the best place to start.. Note: 1. Includes alignment with government objectives, ordering long lead items and developing contracting strategy 8

Written by: David Roxby Key contacts in our Oil & Gas practice: Randy DeGeer North America rdegeer@marakon.com +1 (312) 377-2362 About Marakon Marakon is a strategy and organizational advisory firm with the experience and track record of helping CEOs and their leadership teams deliver sustainable profitable growth. We get hired when our client s ambitions are high, the path to get there is not clear (or taking too long) and lasting capabilities are as important as immediate impact. We help clients achieve their ambitions for sustainable profitable growth through: Neal Kissel Europe nkissel@marakon.com +44 (20) 7664 3727 Stronger strategies and advantaged execution based on: A better understanding of what drives client economics and value Insight into changing industry dynamics and the context in which clients need to succeed A stronger management framework to generate better ideas and link decisions and actions to value A stronger organization with a more focused top management agenda and well-aligned resources A more confident and effective leadership team that s focused, decisive, and strategic We have a joint team delivery approach where client ownership and engagement is paramount. Partners are highly engaged in the work product and supported by strong analytical and industry relevant capability. We work as advisors and catalysts in close, trust-based relationships with top management teams. 9