EPC (Engineering, Procurement, and Construction) or EPCI (Engineering, Procurement, Construction and Installation) contracts for the construction of floating production units (FPUs) have a poor track record. As clients, oil companies want FPUs delivered on time, on budget, with high quality. For various reasons, contractors rarely reach performance goals set by the client.

The offshore industry as a whole has seen a dismal failure of large EPC projects over the last

Figure 1. Factors influencing the contracting strategy.
decade. Reasons range from aggressive appraisal strategy by operators leading to poor definition of the project to sloppy performance by contractors whose focus is only on protecting profits and avoiding penalties.

Decreasing profit margins on EPC contracts have been publicly reported by most of the contractors in recent years. Many operators have also experienced massive losses due to time and cost overruns in their EPC contracts, which in turn has made their profits less significant in the light of a discounted cash flow analysis.

From the company perspective, one major source of uncertainty in the pre-bidding phases is the definition of the execution period for the EPC work. The company should estimate properly both the execution period and the price expected to be paid for the EPC at the outset of the project so that the economic indexes can be worked out through a discounted cash flow analysis. If the cost and duration of the execution phase are overestimated, then the project may no longer be feasible.

On the other hand, underestimating cost and duration may lead to high expectations with respect to the expected return of the project, whose real figures will be unveiled just at the end of the tender process. So the company’s staff should be conscious of and updated on market indices and facilities availability when pricing and scheduling the execution phase of FPUs.

In addition to difficulties in predicting duration and cost of the execution phase by the company, another aspect of paramount importance is the extreme need of some contractors to win the contract. In this case, bids can be unrealistically low and the execution schedule dangerously and adventurously short. This situation, with the contractor as sly salesman and the company as shortsighted client, causes this vicious circle:
• The company sets an unrealistic time frame to first oil, which leads to a significant profit;
• Contractor bids low and accepts the time frame for the execution phase;
• Progress payments by company are postponed since milestones are not met;
• Contractor faces a liquidity crisis and start claiming for variation orders;
• Unsolved disputes over change orders cause more delay;
• FPU is delivered with delay and at a higher cost;
• First oil is reached far later than the planned schedule and the economics of the project are reviewed;
• Both contractor and company allege financial losses and the blame game starts;
• Company sets audacious time frame for a new project in the hope of attracting partners and investors and of justifying the investment for the stakeholders.

To reduce the risk of entering this vicious circle, the company should first consider realistic time frames and cost appraisals accompanied by a change of the culture regarding the awarding philosophy of the EPC Contract. Usually the contractor with the lowest bid is awarded the contract without further consideration. It does not matter if the contractor underestimated the project risks or overestimated its ability to take the work.

The company should be concerned about the criteria for the pre-bidding selection of contractors. But the bid price should not be the only criterion for the contract award. A low bid may represent the lack of a thorough assessment of the project risks and, as consequence, the lack of a contingency. So, the lowest bid does not necessarily lead to highest value when we consider the whole life cycle of the project (until decommissioning the FPU), where quality performance is essential. So, the company should set apart “good” and “bad” tenderers as far as the measures of performance of the project are concerned.

The recurring situation described above can be even worse if we consider that most of the time the degree of definition required for the start of the execution (EPC) phase is not attained and the contractor cannot start the procurement of materials and long-lead equipment immediately after contract award. Most oil companies have also been over-eager to fast-track projects aimed at early production. This phased construction (fast-track), where the FPU is built while it is designed, entails a lot of risks that need to be properly assessed beforehand.

Fast-track execution models need a good understanding of the interdependency of tasks and a good coordination skill by the lead contractor to assure that all work will interface without gaps or overlaps of responsibility. If the interfaces between the various scopes of the work of different subcontractors is not worked out and long-lead equipment is not procured in advance, the phased execution model will be doomed to failure. This stresses the importance of a consistent front-end loading so as to avoid conflicts in the FEED and detailed design phases and speed up the procurement phase.

Factors that affect contracting strategy

The application of Pareto Principle to the process of selecting the most suitable contracting strategy leads to the “vital few” factors presented in Figure 1. They can be regarded as the fundamental factors of merit that would help make more informed decisions.
Unlike the external factors in Figure 1 that we have no control over, internal factors are those that are part of the organization (oil company) and to a large extent under its control.
From the author’s standpoint, external factors prevail over internal ones when deciding the most appropriate contracting strategy. This conclusion looks obvious because oil companies are usually flexible enough to adapt their organizational structure and increase their risk exposure if required for a given contracting scenario. On the other hand, they have no control at all over the petroleum legislation in the host country or the offshore construction market.

External influences

Oil companies are confronted with many restrictions regarding the number and type of EPC contracts. A public tender is usually required to let an EPC contract, and a tender process with a public bid opening date is set for this purpose. Negotiations between the company and potential bidders (contractors) are not allowed until the winning bidder is known. This lack of freedom to negotiate and execute contracts because of the strict regulations of some countries has caused an increase in the use of lump-sum, turn-key contracts over other contracting models.

Many oil companies doing business in countries in West Africa and the Far East have adopted lump sum turn-key contracts as standard for their FPU projects. They also do it to reduce their risk exposure because they have no control over the approval cycle time by the local petroleum authorities. So the more contracts the scope is split into, the more likely that interface problems will arise from the award of key contracts in a random fashion.
In addition to the regulatory environment, another external factor is market conditions around the time of project sanction. Market conditions encompass the commodity price and the availability of facilities to fabricate and integrate the platform and its topsides. High commodity prices and high demand for floaters increase the negotiating power of the contractor; idle facilities and low commodity prices increase the negotiating power of the company.

At present, oil companies are eager to secure slots in shipyards for conversion or construction of FPUs. Oil companies have been reserving shipyard slots and spaces in fabrication yards 1 or 2 years ahead of construction kickoff to assure the structure is delivered on schedule. As a result of this robust cycle of platform construction, oil companies have agreed to share the cost risk and let contracts on a unit rate basis or even on a reimbursable basis (cost plus with a guaranteed maximum price). They have also been more flexible with respect to the contractor’s liabilities, accepting lower caps on liquidated damages, loss and damage, damages to the environment and so on.

Higher crude oil prices over the past 2 years have also caused a change in the way oil companies manage their field development projects. The majority of projects being developed today are primarily driven by schedule because the cycle time from discovery to first oil is the most influential parameter affecting project economics. We have seen an over-eagerness to fast-track projects aiming at the early production of the field. This has favored the use of incentive arrangements linked to key delivery milestones.

Although the use of incentives in EPC contracts is a common practice, the track record of past projects using incentives indicates that a small reduction in CAPEX and a shorter delivery time were obtained at the expense of an operational under-performance. The point is that contractors have not been capable of establishing and benefiting from a learning curve in these projects since they require a high degree of complexity and innovation and are usually tailored to particular scenarios.

Influences on the contracting model

The most influential internal factors affecting the contracting strategy are the company’s
Figure 2. Representation of the Risk Allocation in Function of the Compensation Philosophy (Source : Adapted from Dunlop, J. et al. “Impact of Risk Allocation and Equity in Construction Contracts,” Construction Industry Institute Source Document 44, March 1989)
organization and its aversion to risk. Risk-averse companies always let EPC contracts on a fixed-price, lump-sum basis. Lump-sum pricing arrangements are also less staff-demanding. Oil companies that go for single lump sum contracts deliver a clear message that they rely on the management and leadership skills of the contractor and that they agree to pay a premium to the contractor for bearing the cost uncertainty (Figure 2).

There is also a close link between the organizational structure of some oil companies and the way they let FPU construction contracts. Some oil companies have a more project-oriented structure, with a well-defined team fully dedicated to the project and some support provided by the discipline organization of the oil company. Some oil companies have even set up a business area responsible solely for the execution of their projects from the select phase to the start of production.

From an oil company perspective, this organizational approach favors the use of riskier contractual arrangements such as a combination of multiple fabrication contracts and reimbursable compensation. Some other oil companies are structured in a matrix fashion, where only a small core team is assigned full time to a single project and the parties (departments and business units of the company) make the decisions collectively. Unlike the project-based approach, this organizational model favors a more conservative arrangement such as a single, lump-sum, turn-key contract, because decisions are not promptly taken and the project is usually staffed to oversee contractor activities only.

Standardized risk mitigation

Some oil companies have adopted a “design one, build multiple” philosophy where a standard design is used to build multiple platforms for different scenarios. The only design changes are those that improve operational or HSE (Health, Safety, and Environment) performance of the vessel. Apart from a few justified circumstances leading to changes, all equipment and materials are procured “as supplied” to the pioneer project.

ExxonMobil was very successful in applying this philosophy to the FPUs (ship-based FPSOs) of Kizomba A and Kizomba B, offshore Angola. By sticking to the original design for Kizomba A, ExxonMobil estimates that about $400 million in development costs were saved and 5 months were cut off the delivery time for Kizomba B. These reductions in time and cost were obtained because of an increase in execution efficiency and the standardization of materials, equipment and procedures from A to B.

Another major benefit concerns training and safety of the crew, who are able to efficiently operate both vessels.

Frame agreements also have been widely used by oil companies. They are long-term agreements between the company and a supplier for critical equipment during a given time period. Equipment specification is predefined, and prices are agreed at the outset. Material and labor escalation clauses are included in the contract. The main benefit for the company is reduction of acquisition costs and operational costs and a shorter delivery time. Suppliers benefit from a long-term supplying arrangement without the need to go through a tender.

Conclusion

There is no best contracting strategy. We have seen projects executed successfully under different contracting models. Those successful projects have in common a proper connection between the organizational structure of the company, its tolerance to cost risks and the project execution model adopted, which encompasses the contracting strategy. Some companies have been successful recently performing not only the FEED but also the detailed FPU design in addition to working as main contractor managing all the interfaces during the execution phase. Other companies have succeeded in involving the EPC company from the design phase, integrating their own teams into the contractor’s design team and coming up with positive outcomes for the project metrics.

In short, the most suitable contracting strategy for a particular scenario should take into account all the constraints in petroleum sector legislation and the international construction market and reconcile them with the corporate culture and organizational structure of the oil company. The external factors shown in Figure 1 set the boundaries and help to screen out unsuitable arrangements for the contracting model. The contracting strategy should fit well into the project execution model adopted by the oil company, which in turn should reflect its preferences.

The company should take advantage of lessons learned from past projects, in-house expertise, ongoing frame agreements with fabricators and suppliers, willingness to develop and apply new technologies, credit rating and cash availability, working relations with regulatory authorities and so on, when letting a contract.

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