By John Kemp
LONDON, Sept 6 (Reuters) - The market for giant engineering projects has begun to cool after running red hot for a decade. Mining companies have been among the most aggressive in postponing or cancelling projects, but major capital expenditures are also being deferred by oil and gas companies and refiners.
Like most other developments in the oil and gas sector, the changing environment for large-scale projects stems from the shale revolution. Shale has transformed the outlook for oil prices and sources of supply that underpinned so many of the megaprojects launched earlier in the century.
Rather than the technically complex megaprojects that were expected to provide almost all the extra oil and gas supplies at the start of the century, the oil and gas industry now expects much of its future output to come from shale formations.
Shale has burst into the middle of the cost curve, with a profoundly disruptive influence on the rest of the industry, especially for high-cost, high-risk and capital-intensive megaprojects.
Costing just $50-80 per barrel, shale is more expensive than some conventional production in well-established plays like the Middle East, but far cheaper than complex offshore engineering projects like Kashagan in the Caspian.
Developing shale formations is much more like a manufacturing process, with an emphasis on standardisation and cost control to deliver value, rather than megaprojects, where the emphasis has more often been on bespoke technology and integrating complex processes.
Even an expensive shale well is likely to cost only $10 million - compared with $100 million for a single ultra-deepwater well. Shale development rewards exploration and production firms and contractors who can hundreds of wells as cheaply and quickly as possible by employing techniques learned from mass production manufacturing.
The nature of capital expenditure is changing, from a focus on complex megaprojects focused on a handful of giant oilfields and super-abundant wells to developing thousands, even tens of thousands, of wells across a wide area as efficiently as possible.
Fluor, the largest publicly listed engineering and construction company by market capitalisation and the value of projects in its pipeline, with a diversified portfolio across sectors and regions, is a good marker for the state of the wider capital construction market. Only privately-owned Bechtel is bigger.
Between July 2012 and June 2013, Fluor completed more work on existing engineering and construction than it won in new business, signalling that the capital expenditure cycle for large projects in oil, gas, refining and petrochemicals is peaking.
Fluor performed work costing $28 billion but was only awarded new work estimated at only $25 billion, according to company data. The company’s backlog of outstanding project work dipped from a peak of $43 billion at the end of June 2013 to just $37 billion.
Except for a brief drop following the financial crisis, it is the first significant decline in Fluor’s backlog since 2003/2004. It marks a turning point in the global project boom which has resulted in a vast expansion in the engineering sector an enormous escalation in the cost of capital projects.
Between 2003 and 2011, the estimated cost of projects in Fluor’s backlog, similar to the company’s order book, quadrupled from $10 billion to $40 billion. Fluor’s worldwide workforce of skilled engineers, project managers and other staff, doubled from 17,000 to 33,000 (Charts 1-6).
The boom extended to the other major engineering and construction firms such as Foster Wheeler and Chicago Bridge & Iron. Foster Wheeler’s backlog of oil and gas-related projects grew from $1.3 billion at the start of 2004 to $6.7 billion in the summer of 2008, just as oil prices hit their peak and the financial crisis erupted (Chart 7).
Prices spiralled and the industry suffered widespread overruns in both project timetables and costs, as pressure on the supply chain became intense, affecting the delivery of everything from new oil and gas fields to refineries, gas to liquids plants and petrochemical facilities.
Now the market is starting to cool. Fluor has reacted to a shrinking pipeline of new work by cutting staff and trimming its costs. From a peak of 33,600 at the end of March 2012, Fluor has cut the number of salaried employees 8 percent to under 31,000 by June 2013. Similar cost control programmes are evident at other engineering companies.
The best hope for many engineering firms going forward is probably the construction of a string of LNG export facilities in the United States.
Large-scale projects experience frighteningly high rates of failure. Two-thirds of industrial megaprojects, those with a capital cost of more than $1 billion, failed to meet their business objectives according to an assessment written by Edward Merrow, chief executive of Independent Project Analysis, a leading project-appraisal firm.
Failed projects overran original cost estimates or project timetables by more than 25 percent; were 25 percent more expensive than comparable facilities, or were still falling far short of their intended output two years after commissioning.
Most failed in more than one dimension. It was common for projects to bust the budget, over-run the timetable, and still fail to meet expected production targets.
The failure rate has been worst in oil and gas. Oil and gas projects failed to meet their original objectives in 78 percent of cases, compared with a 70 percent failure rate in mining and below 50 percent in LNG.
Among the failed oil and gas projects, the average cost overrun was 33 percent and the failed projects cost 40 percent more than the industry average. “Nearly two-thirds of the petroleum development failures suffered severe operability problems,” two years after they entered production, Merrow wrote.
Large-scale projects became much more prone to failure in an overheated market. Pressures associated with the global construction boom did not cause the failure, but they made projects much more sensitive to errors.
“When the global megaprojects market is hot, there is very little resiliency,” Merrow wrote. “Contractors will not have the personnel on the bench that can be brought in to help rescue a project experiencing difficulties.”
“Similarly, project sponsors usually find themselves understaffed in a hot market environment as they attempt to do too many large projects,” increasing the risk of failure (“Industrial megaprojects: concepts, strategies and practices for success” 2011).
The turn in the contracting market in 2003-2004 from a generation of being a buyers’ market to a decidedly sellers’ market was the most important change in the context for megaprojects and exacerbated the failure rate, according to Merrow.
Now the market is turning again, as attention shifts to shale and demand for huge-scale engineering projects begins to fall.