US EPC contracts focus on cost coverage as resources tighten
The heated downstream construction market will drive more petrochemical owners on the US Gulf Coast to shift from pure fixed-cost, lump-sum contracting to more cost-reimbursable and conversion strategies, according to Jeff Patterson, NAA/LAA Engineering Center leader at the Dow Chemical Company, and Manuel Junco, vice president Houston Operations at Jacobs Engineering.
The availability of EPC contractors and engineering resources combined with the ability of owners to develop high-quality front-end design packages are all influencing the execution strategies for the current pipeline of petrochemical construction projects, the experts said at a Petrochemical Update webinar on April 1.
The resources of operators and contractors are under pressure from the surge in petrochemical projects, despite many of the firms having large balance sheets.
“What you find out in some of the markets in the Gulf Coast is that some of that lump-sum strategy becomes challenging, particularly for some of the larger projects because who can better take on the risk – the owner or the contractor – and typically it's the owner that has the ability to take on that risk,” said Jeff Patterson, NAA/LAA Engineering Center leader at the Dow Chemical Company.
Dow, which typically opts for lump-sum contracts, is pursuing a reimbursable strategy to build a propylene dehydrogenization (PDH) unit, a 1.5 mtpa ethylene cracker and four world-scale polyethylene facilities in Texas.
“We did that to try and make sure we had the resource pool that could work on the first project and then roll over to the second, to the cracker project,” Patterson said.
“And that was one of our strategies for attracting labor – to be able to have a consistent body of work for a number of years to bring people in. In years past, we might have looked more at a lump-sum approach.”
The vast majority of contracts signed in 2014 by Jacobs and Fluor, two major EPC firms, were cost-reimbursable rather than fixed-price, according to the companies’ annual reports.
Before the petrochemical boom in the US Gulf Coast, owners preferred to procure major construction projects via a fixed-price, lump-sum route – the so-called engineering, procurement and construction (EPC) contract. The lump-sum contracts gave owners and financers more certainty about the time and costs it would take to execute a project but at the same time shifted the risks to the EPC providers.
Starting in 2013, the surge in petrochemical project announcements and the wave of bids gave EPC contractors more bargaining power as owners were in a hurry to complete projects quickly. Consequently, cost-reimbursable contracts became more common.
EPC companies typically prefer cost-reimbursable contracts to shield themselves from the burden of escalating costs. These types of contracts generally provide for reimbursement of costs plus some profit, in the form of a simple mark-up applied to the labor costs incurred or in the form of a fee, or a combination of the two.
Some project owners that struggle to create good front-end packages and administer construction projects might also prefer to stay away from lump-sum contracting and opt for conversion contracts or even strictly cost-reimbursable agreements instead, according to Stephen Cabano, president of project management consulting and training firm Pathfinder LLC, who moderated the webinar.
Junco is also seeing a trend toward conversion contracts in the petrochemical sector, whereby the owner brings in a contractor early on under a cost-reimbursable agreement to define the scope of the project and then switches to a lump-sum contract.
“We are seeing lump-sum conversions. We don’t see a lot of straight lump sum,” he said. “There are enough opportunities that contractors, especially on the construction side, can still go chase [so] they don’t have to take an enormous amount of risk.”
Project overruns, cost escalations and uncertainties over energy and feedstock prices, especially in cyclical industries and long-term projects such as hydrocarbon refining, petrochemical, and natural gas, also mean that contractors are less willing to take on all of the risk.
In response, EPC companies and petrochemical owners are increasingly developing more sophisticated contracting models.
According to Junco, even though many petrochemical owners still prefer EPC lump-sum contracts as a first choice, the only option considered by most contractors in the current market environment might be a negotiated lump-sum with carve-outs for labor wages and other options to reduce the risk premium. In most cases, contractors are willing to consider construction-only lump-sum arrangements.
Citing the uncertain energy market conditions, Technip has rolled out a progressive turnkey contractual scheme, whereby a payment is made on a cost-plus-fee basis during the design and procurement phases. Once the project advances, Technip may propose a conversion into a turnkey contract and lump-sum payment.
The company may also choose to exclude certain services such as equipment procurement and/or construction, particularly when design studies are not sufficiently developed at the proposal stage, according to the company’s 2014 annual report.
The progressive turnkey contracting model was first outlined in Technip’s 2008 annual report.
Most of the EPC contracts on the US Gulf Coast at the moment under construction are still cost-reimbursable. At the end of 2014, approximately 81% of Fluor's backlog was cost-reimbursable and 19% was for fixed-price, lump-sum or guaranteed maximum contracts, according to the company’s latest annual report. The breakdown was similar in 2013.
Fluor is currently building three petrochemical facilities on the US Gulf Coast – a 1.5 mtpa Light-Hydrocarbon (LHC-9) ethylene cracker for Dow Chemical in Oyster Creek, Texas; a 1.5 ethylene plant near Cedar Bayou for Chevron Phillips Chemical, in a joint venture with JGC; and 1.5 mtpa world-scale ethane cracker and derivatives complex for Sasol near Lake Charles, Louisiana, in a joint venture with Technip.
Much of Jacobs’s project portfolio is also cost-reimbursable. In 2014, 83% of the company’s revenues came from cost-reimbursable contracts and 17% from fixed-price contracts, including both lump-sum bid and negotiated fixed-price agreements, according to the company’s 2014 annual report. In 2013, 85% of the company’s revenues came from cost-reimbursable contracts.
Over the past five years, most of the company’s fixed-price work has been either negotiated fixed-price contracts or lump-sum bid contracts for project services, rather than turnkey construction.
Similarly, KBR continues to have more cost-reimbursable projects, as announced in its 2014 fourth-quarter earnings. Some 40% of its backlog was attributable to fixed-price (lump-sum) contracts and 60% was attributable to cost-reimbursable contracts. In the fourth quarter of 2013, KBR said 43% was attributable to fixed-price contracts and 57% to cost-reimbursable contracts.