A.Sanchez_The rising cost and risks of large scale capital projects

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]

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� 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


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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


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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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Challenges facing the energy sector


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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



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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



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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


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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



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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


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


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



� 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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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



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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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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



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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



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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)


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


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…

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Conclusion and recommendations


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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]

A.Sanchez_The rising cost and risks of large scale capital projects

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