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THE RISING COST AND RISKS OF LARGE-SCALE CAPITAL PROJECTS IN THE ENERGY SECTOR
Alberto Sanchez January 2017
Alberto Sanchez BEng, MsCLog, MIntBus, GradCertEnSt
By A.Sanchez l [email protected]
2
� Alberto has over 20 years of experience delivering capital projects with values from $100 million to over $10 billion in Asia-Pacific, Middle East, Europe and Central Asia and Latin America in the private and public sector. He has worked across different industries including oil and gas, chemicals, utilities and infrastructure throughout all project phases (feasibility studies through to commissioning) as project controls manager, head of project controls, planning manager and head of capital projects for international oil companies, E&C contractors and consulting firms
� Alberto holds a bachelor degree in civil engineering, master degree in logistics and operations, master degree in business and postgraduate in energy studies from recognised Australian universities. He is often requested as a keynote speaker at major companies and industry conferences worldwide on planning/scheduling, risk management and modular construction.
� He is always interested in hearing from former colleagues, clients, or just interesting folk, so feel free to contact him
Contents
By A.Sanchez l [email protected]
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� Main objectives � Project economic feasibility � Challenges facing the energy sector � Cost estimates and decision making � Cost optimisation opportunities � Project risks and uncertainties � Cost benchmarking � Cost estimate assurance � Major causes of cost overruns � Conclusion and recommendations
Main objectives
By A.Sanchez l [email protected]
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� Understand the major challenges facing the energy sector
� Understand the relation between accurate cost estimates and quality decision making
� Understand the opportunities of cost reduction during the project lifecycle
� Estimate the project risks and cost uncertainties � Identify the major cost risks and opportunities
Project economic feasibility
� The feasibility and approval of a new capital project requires the gathering of essential information
� Each of those pieces of information has inherent risks and uncertainties that can have impact to the decision outcome
Capital expenditure (CapEx)
Operating expenses (OpEx)
Estimated production profiles
Concession terms
Fiscal (tax) structures
Estimated commodity prices
Project schedule
Stakeholders’ expectations
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By A.Sanchez l [email protected]
Challenges facing the energy sector
By A.Sanchez l [email protected]
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� The energy sector has always been seen as a high-risk / high-reward business
� Yet, risk factors such as price volatility, geopolitics, regulatory climate, etc. have become more difficult to manage
� Commodity price fluctuations are nowadays more related to macroeconomic and political factors than supply and demand factors
Challenges facing the energy sector
By A.Sanchez l [email protected]
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•Projects are more complex and risky due to the uncertain global socio-economic environment (e.g. political climate, resource nationalism, security risks, trade and financial sanctions, etc.)
Geopolitical environment
•Price distortions among regions caused by supply chain constraints creating arbitrage opportunities (e.g. political tensions or other speculative factors)
Prices volatility
•Rising project costs have played an important role in the decline of energy projects profitability; large number of capital projects are facing cost overruns and/or delays
Rising costs and delays
•Investments in regions without mature legal or regulatory frameworks (e.g. unrealistic local content, ambiguous project approvals, government price vulnerability)
Regulatory climate
•Delay building or revamping infrastructures outside project scope causing bottlenecks in construction or production (e.g. inadequate export pipeline, unreliable power supplies, constrained port terminal, etc.)
Infrastructure dependency
•After years of sustained high commodity prices some projects have dropped significantly outside the acceptable threshold of returns required by shareholders
Project financial performance
Challenges facing the energy sector
By A.Sanchez l [email protected]
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� As a result, now more than ever energy companies carefully select the projects to invest in order to ensure the expected return on capital and ultimately shareholder return
� Yet, cost overruns are becoming increasingly common for large energy development projects
� Many times the cause of the problem can be traced back to inaccurate cost estimates and insufficient risk assessment during the early project life cycle, leading to subsequent cost growth
Cost estimates and decision making
By A.Sanchez l [email protected]
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The accuracy of the cost estimate is critical for decision-makers to choose whether or not to proceed to the next phase of the project
Over-estimate can lead to decisions to terminate an economic project (or lucrative business opportunity)
Under-estimate can lead to significant cost and schedule overruns and in some cases costly decisions to terminate the project in a late-stage
Cost estimates and decision making
By A.Sanchez l [email protected]
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Key factors to consider when developing a cost estimate :
Understand the purpose of
the cost estimate (e.g. feasibility, budget
authorization, control, etc.)
Understand the level of project definition to provide the level of accuracy of the cost estimate (e.g. -10% to
+20%)
Understand the quality of the project information available
during the cost estimate
Understand the cost estimating capability available within the
organisation in terms of processes, resources and tools
Understand and estimate the cost impact ranges from risks,
uncertainties and opportunities
Understand the cost estimate is one of the most important
pieces of information to determine the economic
feasibility of the project and approval to proceed to the
next project phase
Cost estimates and decision making
AACE Cost Estimation Classification
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PHASE 1 Identify
PHASE 2 Select
PHASE 3 Define
PHASE 4 Execute
PHASE 5 Operate
ESTIMATE CLASS Class 5 Class 4 Class 3 Class 2 Class 1
LEVEL OF PROJECT DEFINITION DELIVERABLES
0% to 2% 1% to 15% 10% to 40% 30% to 75%
65% to 100%
END USAGE Typical purpose of estimate
Concept screening
Study or feasibility
Budget authorisation
or control
Control or bid/tender
Check estimate (on actual costs)
METHODOLOGY Typical estimating method
Capacity factored, parametric models,
judgment, or analogy
Equipment factored or parametric
models
Semi-detailed unit costs with
assembly level line items
Detailed unit cost with forced detailed take-
off
Detailed unit cost with detailed
take-off
EXPECTED ACCURACY RANGE Typical variation in low and high ranges
L: -20% to -50% H: +30% to +100%
L: -15% to -30% H:+20% to
+50%
L: -10% to -20% H: +10% to
+30%
L: -5% to -15% H:+5% to
+20%
L: -3% to -10% H:+3% to +15%
DG1 DG2 DG3 DG4
Decision Gate
Cost optimisation opportunities 12
Establish preliminary scope and business strategy
Establish development options and execution strategy
Finalise scope and execution plan
Detail and construct asset
Operate, maintain and improve asset
DG1 DG2 DG3 DG4
Major Influence
Rapidly decreasing influence
Low Influence
High
Low
Large
Small
Expenditures
Influ
ence
ove
r co
sts
Expe
nditu
res Influence
Uncertainties
By A.Sanchez l [email protected]
The graph shows the importance of making the right decisions early in the project lifecycle
There is a clear link between decreasing ability to influence project costs and increasing maturity of the
project in the lifecycle
Project risks and uncertainties
FID = Final Investment Decision
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Proj
ecte
d fin
anci
al p
erfo
rman
ce
(NPV
, RO
I, IR
R) Hurdle rate
Minimising the negative impact of project cost growth
Achieving the expected hurdle rate
Establish preliminary scope and business strategy
Establish development options and execution strategy
Finalise scope and execution plan
Detail and construct asset
Operate, maintain and improve asset
Hurdle Rate: the minimum rate of return on a capital project required by the shareholders Minimising negative impact: The effort by the company to reduce costs and/or reduce the risk impacts (e.g. cost overruns, delays)
• Several projects report cost overruns compared to the approved cost estimate (authorised budget) resulting in poor economic results
• Early cost estimates may not adequately assess the project risks and uncertainties causing potential cost growth
DG1 DG2 DG3 DG4
Project Sanction/FID Gate
By A.Sanchez l [email protected]
Project risks and uncertainties
� As the project moves through the project phase gates, risks should be formally assessed to determine the likelihood of achieving the expected return on capital and ultimately shareholder return
� The use of appropriate processes and tools to identify and quantify project risks and uncertainties can help decision-makers to decide whether the project is ready to proceed to the next phase
� Project cost risk analyses can help to assess the level of accuracy of the cost estimates and make better informed decisions
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By A.Sanchez l [email protected]
Project risks and uncertainties
By A.Sanchez l [email protected]
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Example:
� Final location of the proposed new facility � Local or regional market conditions � Availability of qualified E&C contractors � Increase of original estimated quantities � Availability of skilled workforce � Expected productivity of workforce � Changes to local content requirements � Availability of specialised construction equipment � Closure of preferred route for heavy and oversize vehicles � Extreme weather conditions � Others
Project risks and uncertainties
By A.Sanchez l [email protected]
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� Cost risk analysis and benchmarking can improve considerably the quality of the decision-making process
Frame the capital investment
decision (e.g. strategy, project
targets, shareholders’ expectations)
Identify the project risks and uncertainties (e.g. market conditions, material prices,
etc.)
Quantify the project risks and uncertainties (e.g.
project cost ranges,
probability distributions)
Benchmark and compare the
proposed new facility to
historical project costs (e.g.
$/tonnes/year)
Better Decision-Making
Example: Process Plant in Europe
� The cost risk analysis shows that the project is unlikely to meet the anticipated capital cost (CapEx) of $1.40 billion
� There is a probability that the project will be $400MM to $600MM higher than the anticipated capital cost
� If the minimum return on capital can be met despite potential higher capital cost then decision-makers can choose to proceed to the next phase of the project
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By A.Sanchez l [email protected] $1,500,000,000 $2,000,000,000
Distribution (start of interval)
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
Hits
0% $1,459,692,915
5% $1,594,554,808
10% $1,633,003,564
15% $1,671,631,159
20% $1,702,343,433
25% $1,737,849,722
30% $1,765,688,623
35% $1,785,516,891
40% $1,802,065,862
45% $1,820,707,140
50% $1,843,753,414
55% $1,859,762,710
60% $1,877,174,383
65% $1,898,244,014
70% $1,911,301,973
75% $1,926,764,697
80% $1,947,126,710
85% $1,969,288,577
90% $1,999,687,047
95% $2,046,326,210
100% $2,191,720,516
Cum
ulat
ive
Freq
uenc
y
Example: Process Plant in Central EuropeCost Risk Analysis
Anticipated capital cost (CapEx) = $ 1.40 billion
Example: Process Plant in Europe 18
� Major project risks
5%
7%
7%
9%
13%
16%
16%
21%
23%
28%26 - Delay in construction due to changes during detailed design
22 - Changes during the incorporation of optimisations in the detailed design
20 - Major changes to basic design parameters
25 - Delay in approval of E&C contractor selection by stakeholders
24 - Rejection of technical options during detailed design reviews
10 - Shortage of qualified personnel to manage the project
15 - Poor management and integration of subcontractor(s)
40 - Change in local regulations for imported goods
55 - Lost Time Incident (LTI) due to lack of safety culture by local subcontractors or workers
30 - Design changes after placement of purchase order(s)By A.Sanchez l [email protected]
Cost Benchmarking
� Benchmarking has long been used to improve the accuracy of project performance
� It is the process of comparing the estimated capital costs of the proposed new facility against the results of similar projects in the industry
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By A.Sanchez l [email protected]
PROJECT COST ESTIMATE REPORT
DEVELOP COST METRICS
COST DATA COLLECTION
SYSTEM
COMPANY PROJECTS
(INTERNAL)
SIMILAR PROJECTS/
NORMS(EXTERNAL)
CONDUCT COST BENCHMARK COMPARISON
VALIDATE COST ESTIMATE
Example: Process Plant in Europe
By A.Sanchez l [email protected]
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The following analysis is based on a cost database including actual information of similar process plants completed by the company
� Proposed new facility : � Capacity = 8 billion m3 per year
� Benchmark project: � Capacity = 9 billion m3 per year
Example: Process Plant in Europe
By A.Sanchez l [email protected]
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� The anticipated cost estimate is about 23% below the benchmark and � The worst case scenario (P90) is about 12% above the benchmark
� The most likely scenario (P50) against the results of similar projects are very
close and meets the minimum return on capital for decision-makers to proceed to the next phase of the project
Cap Benchmark
Cost Estimate Scenario Cost Estimate
Original Scenario
P50 Scenario
P90 Scenario
Using benchmark values
Benchmark project 9 billion m3 per year
$ 2.20 billion
$ 1.40 billion
$ 1.84 billion
$1.99 billion
$ 1.82 billion
Proposed new facility 8 billion m3 per year
Delta versus benchmark values
≈ -23% ≈ +1% ≈ +12% 1 (base)
Anticipated capital cost (CapEx) = $ 1.40 billion
Cost estimate assurance
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� Most companies perform a “cost assurance review” as part of the project gates
� The aim is to produce an independent review of the confidence level of the cost estimate of the proposed new facility
� This often becomes a basis for authorisation to move to the next project phase (e.g. execution phase)
By A.Sanchez l [email protected]
PHASE 1 Identify
PHASE 2 Select
PHASE 3 Define
PHASE 4 Execute
PHASE 5 Operate
ESTIMATE CLASS Class 5 Class 4 Class 3 Class 2 Class 1
LEVEL OF PROJECT DEFINITION DELIVERABLES
0% to 2% 1% to 15% 10% to 40% 30% to 75%
65% to 100%
END USAGE Typical purpose of estimate
Concept screening
Study or feasibility
Budget authorisation
or control
Control or bid/tender
Check estimate (on actual costs)
DG1 DG2 DG3 DG4
Cost estimate assurance
Cost estimate assurance 23
PRO
JECT
TEA
MPR
OJE
CT C
OST
ES
TIM
ATE
TEAM
COST
ASS
URAN
CE T
EAM
THIR
DPA
RTY
(if a
pplic
able
)
* COST ESTIMATE REPORT* TECHNICAL DOCUMENTATION
COST ESTIMATE REVIEW REQUEST
COST BENCHMARK REVIEW:* UNIT COST RATES* LABOT COST RATES* PRODUCTIVITY RATES* COST RATIOS OR RANGES FOR: * INDIRECT COSTS * FREIGHT * INSURANCES * VENDOR ASSISTANCE * COMMISSIONING
COST ESTIMATE WITHIN INDUSTRY
NORMs and/or ESTIMATE
EXPECTATION?
ACCEPT PROJECT COST ESTIMATE
YES* PREPARE INDEPENDENT COST ESTIMATE FOR COST COMPARISON* IDENTIFY AREAS OF COST IMPROVEMENT* ESTIMATE COST OF TECHNICAL OPTIMIZATION RECOMMENDATIONS
NO
IDENTIFY AREAS OF TECHNICAL
OPTIMISATIONS
REVIEW AND UPDATE COST ESTIMATE REPORT
PREPARE OFFICIAL LETTER WITH COST ESTIMATE REVIEW COMMENTS &
AGREED TECHNICAL OPTIMISATION
RECOMMENDATIONS
PREPARE INDEPENDENT COST BENCHMARK REVIEW
ANALYSIS REPORT
FINAL COST ESTIMATE COMPARISON REVIEW
COST ESTIMATE WITHIN INDUSTRY
NORMs and/or ESTIMATE
EXPECTATION?
ACCEPT PROJECT COST ESTIMATE
YES
NO
* DECREASE SCOPE* DEFER CAPEX* SIMPLIFY FACILITY* CONSIDER ALTERNATIVE STANDARDS* CONSIDER ALTERNATIVE CONTRACT STRATEGY* CONSIDER ALTERNATIVE CONSTRUCTION METHODS* OTHERS
JOINT REVIEW OF TECHNICAL
OPTIMISATIONS
IDENTIFY AREAS OF TECHNICAL
OPTIMISATIONS
By A.Sanchez l [email protected]
Major causes of cost overruns
� Wrong contract strategy � Wrong selection of
contractor(s) � Wrong construction method � Incomplete design at the time
of bidding E&C � Design errors and omissions � Scope changes and/or late
modifications � Poor planning and interface � Late equipment deliveries � Inaccurate cost estimates � Schedule-too-optimistic
� Poor productivity � Regulatory changes � Late decisions (price
fluctuations) � Project deferred � Interface with other projects � Lack of experience � Others…
24
By A.Sanchez l [email protected]
Conclusion and recommendations
By A.Sanchez l [email protected]
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� Inaccurate project costs can lead to incorrect decisions
� Inaccurate estimates can result in inefficient use of resources and late projects
� Clear cost expectations in the early phases of the project is crucial
� Ignoring a risk will not eliminate its potential impact � Used correctly, benchmarking can add value to the
project by improving accuracy of the project cost estimate
THE RISING COST AND RISKS OF LARGE-SCALE CAPITAL PROJECTS IN THE ENERGY SECTOR
Contact: [email protected]