Asset Performance Networks

MODELING INTERNATIONAL ESCALATION

FACTORS FOR UPSTREAM E+P PROJECTS

- AN ECONOMICS PERSPECTIVE -

By

Jan A. Jackson, MBA, MIB, PMP, CCC(Senior Consultant – Project Consulting Services (2007))

Washington D.C. Office3 Bethesda Metro CenterSuite 925Bethesda, MD 20814Tel: +1 (240) 683-1001Fax: +1 (240) 683-1009

Table of Contents

ABSTRACT

KEYWORDS

1. INTRODUCTION.............................................................3

1.1 Background................................................................3

1.2 Objectives...................................................................3

2. THEORETICAL CONTEXT............................................3

2.1 Escalation defined..............................................3

2.2 Definitions and Economics.................................5

3. ESCALATION INDICES.................................................6

3.1 Required Index Components..................................6

3.2 Other (Industry) Escalation Indices...................9

ABSTRACT

This paper is focused on establishing a method for a modified escalation model that produces more specificity for project cost comparisons among

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certain types of upstream projects. Many escalation models fail due to either lack of appropriate detail or requirements to maintain too many complex routines. In short, any model needs to deliver the appropriate amount of information without becoming a burden. This study will also address the concept of location factors and the challenges in dealing with sourcing issues for respective commodities. Within the last five years several major commodities such as steel or cement have experienced exorbitant price increase on the global markets due to increased demand from developing economies. The demand pull exerted by China’s expanding economy has broken the continuity of slow but steady project cost increases for global capital projects. This paper presents considerations regarding escalation indices for projects like pipelines, offshore, and onshore to enable reasonable economic comparisons.

KEYWORDS

Escalation, inflation, producer price index, commodity, sourcing, location

factor

1. INTRODUCTION

1.1 Background

Currently used escalation factors for comparisons of E+P (Exploration and Production) projects often appear to produce disproportionate and questionable results in comparison to project costs from different time periods. More specifically, the driver behind this exercise is the apparent understatement of the amount of cost escalation calculated based on the (Consumer Price Index) CPI index used in many costing systems. This document recommends a more accurate approach and set of indices to escalate costs and demonstrate the differences to currently used models.

1.2 Objectives

Efforts here are focused on detailing a method or structure for a modified escalation model that may produce more specificity for project cost comparisons. Further, but to a lesser degree, this study will address the concept of location factors and the challenges in determining sourcing issues for respective commodities. Within the last five years several major commodities such as steel or cement have experienced exorbitant price increase on the global exchanges due to increased demand from developing economies in general and China in specific. The demand pull exerted by China’s expanding economic activity has broken the continuity of moderate but steady cost increases for capital projects around the world.

This document presents a set of escalation indices for pipelines, offshore, and onshore projects to allow for a reasonable project-to-

project comparison and account for the unusual escalation within the last several years.

2. THEORETICAL CONTEXT

2.1 Escalation defined

In recent years drastic price changes for certain commodities, such as steel and cement have upset not only financial markets, but integrated economic entities along the value chain as well. China’s appetite for resources to feed its rapidly expanding (and transitioning) economy is possibly the most dominant factor in observed commodity price hikes and spikes of late. Escalation is a pronounced and continued increase in the cost basis of certain, specific economic production factors over time. It is frequently tied to one commodity or industrial sector and initially impacts producers of goods whereas inflation represents a general price increase across the broad spectrum of an economy.

In the long run however cost escalation is passed on to the end consumer in form of higher prices and thus ultimately ‘bleed’ into inflation and the CPI. In order to adequately capture project cost information over time and ensure comparability among projects some E+P companies have established proprietary projects systems to track costs according to an established Cost Breakdown Structure (CBS) by ‘Project Type.’ The following simplified figure uses both of these elements in developing appropriate indices to track escalation:

Figure (1) – Index Development Chart

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E+P projects systems may define several major project categories, such as ‘Pipelines’, ‘Offshore’, and ‘Onshore’ to capture type-specific information (see above figure, Level 1). Currently, cost escalation is often accounted for in many costing systems by applying a common, yearly inflation factor across all project categories. However, each project category is characterized by a unique cost composition, which therefore will produce different escalation profiles.

In the above figure, Level 2 depicts one possible distribution of common cost types for each project category. Level 3 is a further refinement of the previous level to break down broad cost types such as ‘material’ into distinct sub-categories (steel, concrete, etc.). In order to present an alternative to currently used CPI-based escalation models, this paper has defaulted to escalating only the ‘dominant’ sub-category for each cost type (e.g. steel pipe being the dominant materials item for ‘pipelines’). Level 4 then assigns the appropriate (commodity or producer) price index to each cost type.

The Bureau of Labor Statistics of the United States (BLS) compiles weekly, monthly, and annual data on a wide variety of economic issues [1]. As an additional feature, it is feasible to consider the impact of ‘local content’ procurement on project cost, as some commodities may show significant differences in market price by locality if it is not traded globally as such. These considerations must be balanced with potentially higher freight and delivery costs when ordering from foreign markets. The model used in this document does consider issues of domestic v. foreign sourcing as displayed on Level 4 in Figure (1).

2.2 Definitions and Economics

Producer Price Index (PPI) data are commonly used in escalating purchase and sales contracts. These contracts typically denominate specify dollar amounts to be paid at some point in the future. It is

often desirable to include an escalation clause that accounts for changes in input prices. For example, a long-term contract for steel may be escalated for changes in scrap metal prices by applying the percent change in the PPI for wheat to the contracted price for steel.

The PPI is a family of indexes that measures the average change over time in selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. This contrasts with other indices that measure price change from the purchaser's perspective, such as the Consumer Price Index (CPI). Sellers' and purchasers' prices may differ due to government subsidies, sales and excise taxes, and distribution costs.

3. ESCALATION INDICES

3.1 Required Index Components

Many models fail due to either lack of appropriate detail and applicability to the business case or too many complex routines for maintaining the escalation model. In other words, the model needs to deliver the appropriate amount of information without becoming a burden and outweighing its benefits. The following chart is taken from several E+P projects studies on upstream projects to show their relevant cost composition.

Figure (2) – Cost Composition by Project Type

The previous chart identifies about ten (10) distinct project cost types. Clearly, each of these cost types could be broken down further into very specific categories. However, the desire for specificity should be weight against the perceived benefit that is gained from applying a more detailed set of escalation indices to an increasing number of cost types. In fact, several main cost types may actually be combined if the nature of their sub-costs suggests strong congruency.

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Figure (3) – Simplified Index Development Model

For example, for our model we have combined ‘Installation’ with ‘Construction/Fabrication’ (labor possibly being the main common sub-cost type). In the following figure the basic sources to arrive at escalation factors are displayed. It is recommended however to consider adjustments to this model based upon specific requirements.

Figure (4) – Tabular Index Weights and Source

The indices in the above table are displayed in the following chart. Clearly, a significant directional change occurred in 2004 with cost increases in many major cost components but most visibly in steel- or metals-related commodities. The CPI index does not display a considerable change in degree of escalation for that particular time period, which may be the cause for disproportionate comparative results when assessing multiple time periods.

Figure (5) – CPI v. Component PPI

100%

31%

06%

33%

30%

OFFSHORE

100%100%TOTAL

Same as ‘ENGINEERING’22%32%INDIRECTS

BLS IC 5413306%05%ENGINEERING

BLS Index of hourly compensation costs for production workers

42%33%CONST.INST. FABRIC.

50% MAT. IC 332312-5

For pipeline (331210-0)

50% EQP. IC 333132

30%30%EQUIP. MAT + O.D.C.

INDEXONSHOREPIPELINECOST

100%

31%

06%

33%

30%

OFFSHORE

100%100%TOTAL

Same as ‘ENGINEERING’22%32%INDIRECTS

BLS IC 5413306%05%ENGINEERING

BLS Index of hourly compensation costs for production workers

42%33%CONST.INST. FABRIC.

50% MAT. IC 332312-5

For pipeline (331210-0)

50% EQP. IC 333132

30%30%EQUIP. MAT + O.D.C.

INDEXONSHOREPIPELINECOST

ESCALATION INDEX DEVELOPMENT

PIPELINE (B1) EQUIP. MACH (a1)

DETERMINE PROJECT

CATEGORIES

DETERMINE APPLICABLE COST TYPES

IDENTIFY BLS INDEX PER COST

TYPE

MULTIPLY BLS INDICES BY

WEIGHT

IN %

PROJECT TYPES COST TYPES WEIGHTINDEX

COMBINE . WEIGHTS

ONSHORE (B2)

OFFSHORE (B3)

MATERIAL (a2)

LABOR/CONTRACT (a3)

ENGINEERING/IND. (a4)

IN %

IN %

IN %

BLS INDEX a1

BLS INDEX a2

BLS INDEX a3

BLS INDEX a4

FACTOR

B1

B2

B3

The comparison of escalation factors according the weights determined per the specific project type is displayed in the following chart:

Figure (6) – Project Types v. CPI

Despite the already significant disparity in escalation development between the CPI and the above displayed project type indices, a comparison to the overall BLS ‘Crude Petroleum + Natural Gas Extraction Index’ reveals a even more drastic differential and suggests significant overheating of this sector in the last few years. Consequently, even the factors calculated in this document may understate the true extent of escalation.

Figure (7) – Comparison to Overall Industry Index

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3.2 Other (Industry) Escalation Indices

The following chart contrasts various commonly used industry indices for comparison. The Nelson-Farrar Refinery Inflation Cost Index [2] is a composite of three sub-components (Material, Labor, and Misc. Equipment).

Figure (8) – Common Industry Indices Comparison

Even though the Nelson-Farrar Index appears to be significantly lower than the developed ‘Pipeline’ index as well as the CPI, it features however an up-tick in 2003-2004 similar in trending to the ‘Pipeline’ index, which corresponds with cost escalations experienced in a variety of commodities during the same timeframe.

Endnotes

[1] See www.bls.gov and www.fedstats.gov

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370.00

ENGINEERING SERVICES

STEEL PIPE

CRUDE PETROLEUM + NATURAL GAS EXTRACTION

[2] The Nelson-Farrar Series of Indices is published in the Oil & Gas Journal, www.ogjonline.com

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