Minimization of an Oil & Gas facility CAPEX can be found in 2 areas: design optimisation and minimisation of equipment/materials and works costs. Cost minimization in these 2 areas takes place at 2 different stages of the project development: BASIC/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. The owner is in a position to influence the costs by, e.g., 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 sub-contracts 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 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. Hence the tendency in some contracts to use a % fee. This can be improved, by using a % fee, e.g., 5% for supply POs and 10% for construction sub-contracts, separate from the compensation to contractor. The compensation to contractor 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 this 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 detailed 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 20 for Engineering & Services, overheads and profit. 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 owner and contractor to jointly make the cost savings, e.g.,
• Decision not to apply the owner specs to the compressor package: 30% cost reduction and delivery schedule reduced by 3 months.
• Order manual valves to a selected supplier in China, outside the owner approved vendors list,
• Optimize the quantity of Passive Fire Protection (see note), reducing construction schedule and cost,
Appealing scheme, isn’t?
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?
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. Indeed:
• The owner must be able to assess proposed deviations to its technical referential. Has he still got the required skills?
• The owner must be in a position to check the conversion prices, including BOQs. Is the owner able to do that?
I think that these are not the real blockers as, if the owner does not have the skills in house they could be found outside.
Maybe the real blocker is that in such scheme the final cost of the project is not known until late. This may not match the Customer requirement for price certainty at project sanction (FID) stage.
If such price certainty is required, we cannot avoid a LSTK, which precludes cost reduction at EPC stage (minimisation 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 specs to save cost, with a 50/50 sharing of the savings?
I do not think this would work. The Owner has no real interest to reduce 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, take time and expose contractor to schedule delays.
As a conclusion, I think that the only way to reduce Projects CAPEX is to do it at FEED (or BASIC design) stage. Experience shows that very large savings can be made. It requires a proper Value Engineering process to be carried out. It shall not be conducted by the FEED contractor whose design must be challenged and for whom any result would lead to rework. The Value Engineering should be conducted by a third party.
This third party must have the expertise of reviewing both the design and owner specifications and proposing cost effective alternatives. Considerable savings are within reach. What is needed is an adequate methodology, including systematic screening tool, along with a collection of proven cost effective technical solutions, with technical justification, ready to be applied. Having started to build expertise in this field for the last few years, I am convinced of its huge potential. I would very much welcome exchanges of experience on this subject with interested readers. Please post the same as comments to this post to make them available to all.
Thanks in advance
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.
Oil and gas facilities projects are developed in two steps: a front-end engineering design (FEED) services contract followed by an engineering, procurement, and construction (EPC) contract.
As companies need to control costs, they resort to lump sum (LS) contracts for the FEED and the EPC.
First of all, when contracting a FEED as a LS, one obtains the bare contractual minimum in terms of studies done, alternatives reviewed, if any, and deliverables. This not only results in lack of project definition but also in missed opportunities to save CAPEX.
The lack of project definition is hard to spot and challenge. How can one tell if enough thought has been put into a drawing? For instance, how do we know if all constraints described in Chapter 5 of “The Oil & Gas Engineering Guide” have been duly considered while establishing the plant layout and producing the plot plan drawings?
The missed opportunities result from the fact that the FEED contractor has no interest to spend hours to find alternatives to optimize the design. The FEED contractor also has no interest to propose alternates/deviations to company specifications.
This last aspect is very unfortunate in the current context of low oil prices and due to the fact that companies have, over the past decades, developed very extensive sets of specifications containing stringent technical requirements. As cost was not an issue then, additions of technical requirements to these specifications were not much challenged. This resulted in numerous onerous and sometimes unnecessary requirements which only a joint review between contractor, that is aware of the cost, and company, which is aware of the operational requirements, could discard.
However such exercises, which includes identification of the onerous requirements, development, justification, and validation of alternatives, take much time which cannot be spent by the FEED contractor under a LS contractual scheme.
Under pressure to make a profit, the FEED contractor spends as few hours as it can.
This not only leads to a nonoptimized design, which is already bad enough, but also to the fact that this design will be over-priced. Here is why.
As already stated, under pressure to save man-hours, the FEED contractor will not go too deeply into project definition. The design of utilities is, for instance, usually overlooked.
In addition, the quality of document produced will be low. Rarely will the FEED contractor, for instance, produce project specifications giving clear, synthetic and project-specific technical requirements. Too often it will merely reference the company’s general specifications resulting in a large amount of nonspecific information to be sorted out at a later stage.
The quality of a FEED is difficult to challenge by the client, as it is also to describe in the FEED services contract.
The quality of the FEED documents will directly affect the quality of the EPC bids. FEED deliverables are the basis that will be used by the EPC bidders for their quotations. EPC bidders do not have time to review documents and revise them, as required, before using them as a basis for cost estimation. The cost estimate is therefore based on the FEED documents. As we know: garbage in, garbage out.
Because not enough effort has been spent at the FEED stage to precisely define technical requirements, or some studies may not have been done or are undocumented, the EPC bidder would need to make assumptions. As these assumptions are made by technical personnel, who are not always fully aware of the cost impact and who are chiefly responsible for the technical soundness, assumptions are often made on the safe side.
In spite of the fact that the FEED quality level is unknown to the EPC bidder, and that it has been contracted under a LS scheme fostering low quality, the EPC bidders are required to endorse it, i.e., to take full responsibility for any error or omission. The EPC bidders have no time to thoroughly check the FEED during the bidding period. They therefore include contingencies in their quotations, inflating the project cost for the client.
Even though one readily sees that having the FEED done under a LS contract and demanding endorsement of the FEED by EPC bidders are clearly conflicting, it is the norm today.
At this stage we see that contracting the FEED services contract as a LS creates a conflict of interest between the FEED contractor and the client. It results in a nonoptimized design. In addition, the client will pay more than it should for this design.
It therefore seems quite obvious that a FEED should not be contracted as a LS contract. Only a reimbursable basis allows design and cost optimization, as well as improved project definition and quality.
This article was initially posted on LinkedIn and attracted considerable attention. Please refer to the valuable comments posted here: https://www.linkedin.com/pulse/why-our-way-develop-projects-fails-minimize-capex-herve-baron.
In Part 2 of this post, we will look at CAPEX minimization at EPC stage.
