Oil & Gas project uncertainty leads to increased risk that can best be mitigated by unique project contracting strategies

Given the current state of the oil & gas industry construction business with soaring costs delaying projects or even causing questions around investment viability, the push to obtain perceived cost certainty via a lump sum on project construction is generally seen as the accepted approach. In the majority of cases, this approach fails to recognize value or manage the true aspects of cost risks, such as contractors incurring significant costs charges from unforeseen labor and material increases as well as additional transactional costs associated with relationship management.

Likewise, contractors who have obtained the price they require prefer being masters of their own destiny in determining the returns on their projects. However, getting oil companies and contractors to agree upon the lump sum price has become more difficult with some contractors now refusing to even quote for construction activities on a lump sum basis.

Although it is recognized that a lump sum can have benefits to both client and contractor in an appropriate situation, the factors governing the decision of when to adopt this contracting strategy need to be carefully considered on a case by case basis rather than clients adopting a corporate de facto lump sum contracting strategy.

Contractors who also take the position of refusing to bid lump sums need to consider that although the decision to bid lump sum in the short term may be commercially attractive, they are opening a Pandora’s Box of new competition in the medium to long term as clients seek new construction partners with creative risk mitigation alternatives.

There Are There More Suitable Alternatives To The Lump Sum Model Given Today’s Global Oil & Gas Construction Market.

If we recognize that defining the best strategy for a contracting model should be tailored for each project based upon individual considerations, it is apparent that there are many more appropriate contract models specific for each company, location, project incentives and contractor availability. suitable for use in today’s market, ranging from controlled reimbursable arrangements, work package management models, target cost with incentives, guaranteed maximum priced models with inflationary readjustments through to convertible lump sums, however, in all of these cases the level of risk the client organization wishes to own and the optimum breadth of global standardization play the most significant part in driving the decision on which model should be utilized.

There Are Critical Issues To Consider In Determining The Most Appropriate Contracting Model.

In our opinion, there are many factors which determine the decision to go with a lump sum strategy and these must be considered on an individual case basis rather than a corporate dictum.

Critical issues include:

• Status and complexity of design
• Project economics
• Work scope definition maturity
• Experience curve progression
• Likelihood of major change
• Timings – start and finish
• Client resource availability
• Market place condition
• Supplier competitiveness

Thorough consideration of these issues as well as many others must be carefully balanced against project specific risk tolerance considerations. An analysis in this manner will aid in identifying the appropriate commercial arrangement suitable for all stakeholders involved in a specific project.

(See illustration 1 Risk Apportionment -v- Contractual Arrangements)

In Summary Best In Class Client Organizations Utilizing Contracting Methodologies That Mitigate Market And Systemic Risk By Balancing All Stakeholder Interests.

Without doubt we will see more flexibility by clients in their use of contract models as they recognize that lump sums are not offering an appropriate solution to construction cost risks without that risk carrying significant pricing premiums.

While client organizations will always work to utilize lump sums the ‘dictum’ approach will not be seen as best in class as long as current market conditions prevail.

We should also see the change in the contracting models impacting upon contractor’s behaviors forcing them to become less commercially aggressive and opportunistic on their tendering or we could be moving towards the day when we see client organizations take on the construction work especially if the balance of risk versus the cost of projects is not balanced correctly.