Why Our Way To Develop Projects Fails To Minimize Capex—Part 2
In the first part of this series, the author explained why the current way of performing FEED does not allow minimization of costs by optimizing the design. In this article, he describes how the current contractual setup of the EPC also fails to minimize the costs of equipment/materials and works.
Editor's Note: In the first part of this series (Why Our Way To Develop Projects Fails To Minimize Capex—Part 1), the author explained why the current way of performing FEED does not allow minimization of costs by optimizing the design. In this article, he describes how the current contractual setup of the EPC also fails to minimize the costs of equipment/materials and works.
Minimization of oil and gas facilities Capex can be found in two areas: design optimization and minimization of equipment/materials and work costs. Cost minimization in these areas takes place at two different stages of the project development: basic engineering and front-end engineering design (FEED) for the former, and engineering, procurement, and construction (EPC) for the latter.
For instance, at the FEED stage the types of isolation valves shown on the piping and instrumentation diagrams (P&IDs) are reviewed to identify where ball valves are really needed vs. much less expensive gate valves.
At the EPC stage, if the supplier of the ball valves is informed of the owner’s specification requirement for the ball valves to be trunnion rather than floating types, the cost is significantly impacted. A review of such a requirement can be done and a deviation may be proposed (e.g., to use floating ball valves up to 3 in.).
Let’s start with a success story. While contracting a FEED as a lump sum, the client made the contractor aware that the current project cost estimate was 40% above budget and that the project would go ahead to 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 of executing it. We strived, challenged the design, and jointly with the owner, reviewed and optimized the design criteria, challenged onerous requirements of the common engineering practices or owner specifications, and proposed alternatives. We managed to get within 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 an approach systematically. To this end, one needs to build a checklist of what is to be reviewed (design criteria, equipment type, codes and 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 reduction as owner specifications have become very numerous and onerous. They were developed during the years when cost was no issue.
Today’s contractual setup leaves no room for any deviations from these very costly referentials.
First of all, at the EPC tender stage, there is 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 subcontractors. 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 lump sum turnkey (LSTK), there is no room to discuss any deviations from these specifications either. The owner and contractor agreed to a fixed price on the basis of the owner specifications. Why would the owner relax the requirements of its specs?
We must find a setup that aligns the interests of the owner and the contractor toward 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 markup 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.
Engineering, Procurement, Construction Management (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/subcontracts 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 also doesn’t offer the client a price certainty.
The open book approach allows the owner and contractor to jointly and progressively decide the design, equipment, vendors, materials, and construction contractors. In such a scheme, the contractor discloses the costs to the owner. These costs are progressively firmed up as the project progresses. The owner is in a position to influence the costs by allowing some deviations from its specs, vendors list, etc. The owner 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 subcontracts would then be placed by the contractor who would bear the cost, schedule, and quality risk. The key aspect to make such a scheme incentivize the contractor to minimize costs is the type of compensation it receives. A percentage 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 subcontract, allowing for inevitable extra costs, is some percentage of the initial purchase order/subcontract value. Hence, the is the tendency in some contracts to use a percentage fee. This can be improved, by using a percentage fee (e.g., 5% for supply purchase orders and 10% for construction subcontracts) separate from the compensation to the contractor. The compensation to the contractor could be a fixed amount, with a gain/pain incentive on the basis of final project cost vs. 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 to deviations which significantly reduce the final project cost.
The trick to implement this scheme, one may argue, is to agree on 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
The owner issues an inquiry for the EPC under an open book convertible approach whereby the contractor shall give a detailed cost breakdown and a target total cost.
Contractor A quotes a target EPC cost of 100 broken down as follows: 10 for engineering and services; 30 for procurement of equipment; 20 for bulk procurement; 30 for construction; and 10 for overheads and profit.
The contract is set up so that the contractor receives a fixed 20 for engineering and services, overheads and profit. The contractor gets an additional 1 for every 5 saved over the target total cost and a penalty of 1 for every 5 spent over the target total cost.
The above scheme enables the owner and contractor to jointly make the cost savings. Some examples are:
Decision not to apply the owner specs to the compressor package: 30% cost reduction and delivery schedule reduced by 3 months
Order manual valves from a selected supplier in China, outside the owner-approved vendors list
Optimize the quantity of passive fire protection (PFP), reducing construction schedule and cost. (Note: An international oil company reviewed the extent of a PFP, a major headache in construction, on similar floating production, storage, and offloading vessels designed and built by different contractors. The quantities of PFP varied from 1 to 3, without reason.)
It’s an appealing scheme, isn’t it?
I know that such schemes are nothing new. In the current low oil price context, they could have become the norm. They are not.
What could be the reasons?
Could it be that by departing from its specifications, the owner gets a substandard 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 lowers 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? Indeed. The owner must be able to assess proposed deviations to its technical referential. Has he still got the required skills? The owner also must be in a position to check the conversion prices, including bills of quantities. Is the owner able to do that?
I think that these are not the real blockers, because if the owner does not have the skills in-house, they could be found outside.
Maybe the real blocker is that in such a scheme the final cost of the project is not known until late. This may not match the customer requirement for price certainty at the project sanction stage, the final investment decision (FID).
If such price certainty is required, we cannot avoid a LSTK, which precludes cost reduction at the EPC stage (minimization of equipment/materials and works costs by justified deviations from owner specifications).
What about having a clause, in the LSTK contract, allowing contractor to propose deviations to owner specifications to save cost, with a 50/50 sharing of the savings?
I do not think this would work. The owner has no real interest in reducing the cost, as the budget has already been approved at FID. As for the contractor, the identification, justification, and agreement on cost savings with the owner uses resources, takes time, and exposes the contractor to schedule delays.
Therefore, the only way to minimize cost in this second area—equipment/materials and works costs coming from onerous client specifications—would be to do it prior to the EPC, at the FEED stage. This requires specific skills: reviewing the owner specifications to identify onerous requirements; knowledge of cost-effective alternatives with technical justification and method; and reviewing and appraising these alternatives with the owner-relevant party (subject matter expert, operations, etc.).
Considerable savings in project Capex can be achieved by optimizing designs and selecting cost-effective technical requirements for equipment, materials, and works. This requires a proper value engineering process to be implemented at the right time by a proper party, having the required tools.
The value engineering methods I came across did not deliver results. They lacked a systematic review of items such as design criteria, overdesign, equipment type selection, and codes and standards, etc.). They also lacked follow-through of any idea up to validation.
The value engineering must be conducted by the right party. It cannot be conducted by the FEED project team itself. There is indeed a conflict of interest: any value engineering finding would lead to rework for the project team.
The party conducting the value engineering must be in possession of a list of commonly found cost savings, with their field of application and technical justification. Collecting such a list takes time and requires investigations. This cannot be done at the project level.
The above points shows that the value engineering process cannot be done at project level but requires a specific function within the contractor’s organization, or a third party. Are there any such functions or qualified third parties? I believe they are missing. That’s why I set out to develop my own practice.
These are my views on the effective way to minimize pojects Capex. Do you share them?
This article was initially posted on LinkedIn and attracted considerable attention. Please refer to the valuable comments here.