(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Sept 3 (Reuters) - Order books for major engineering and construction companies serving the oil and gas sector have fallen in the last year, pricing is becoming increasingly aggressive and profit margins have shrunk, all of which suggest pressures on the engineering supply chain are starting to ease.
Exploration, production and refining in the petroleum industry as well as the supply chain are characterised by long lead times as well as long and pronounced investment and price cycles.
Between 2005 and 2008, the industry struggled to cope with a sudden upsurge in demand. But the boom is now nearly a decade old and the supply chain is starting to adapt.
Falling order backlogs imply a better balance between demand and supply at engineering firms - which should in turn help contain cost pressures and boost supply for the oil and gas industry over the next five years.
Most of the world’s oil refineries, natural gas liquefaction plants, gas-to-liquids plants, petrochemical facilities, mines and electricity transmission networks are designed and built for their owners by just a handful of giant engineering and construction companies that have the expertise to manage these industrial megaprojects.
Engineering, procurement and construction (EPC) companies handle the front-end engineering and design (FEED) work, purchasing of raw materials and components, construction, sub-contracting and project management.
Megaprojects like Qatar’s Pearl GTL plant are so large they create their own “weather” in the global engineering system - driving worldwide price rises for the engineers and specialist supplies required to complete them. Such is the pressure they create on the supply chain, the global engineering industry can only handle a relatively limited number of them at any one time.
Privately-owned Bechtel as well as listed companies like Fluor, KBR, Chicago Bridge & Iron, Foster Wheeler, and smaller specialists like MasTec are responsible for delivering almost all the big projects in oil, gas, petrochemicals and mining.
The main exceptions are some projects managed directly by in-house engineering teams at the major international oil companies such as Exxon and top miners like Rio Tinto and BHP Billiton. But even there, outside engineering companies may be responsible for some of the associated infrastructure.
Like demand for geologists and oilfield services companies, contracts placed with engineering and construction companies are a key indicator of the pace of investment in the oil and gas sector and can show when bottlenecks are emerging in the supply chain.
Across the sector, engineering firms report both the value of new contracts they are awarded and the total “backlog” of work for which they have secured firm contracts but not yet completed delivery.
Backlogs are a useful measure of the project queue. Whether the backlog is growing or shrinking indicates how many new projects are being commissioned, how quickly the engineers are completing existing orders, and how long new projects are likely to be delayed.
In practice, assessing the state of backlogs industry-wide is difficult. Some companies do more work in oil and gas, while others more on power and infrastructure projects. The geographical focus differs with some involved heavily in North America and others with a more diversified client base.
Some firms report the total estimated cost of projects in the backlog, others just the part attributable to them (i.e. net of charges that will flow through to the end client). Bechtel, the largest of them all, is privately owned so does not report detailed information at all.
Nonetheless, Fluor, which is the largest publicly listed engineering and construction company by market capitalisation and backlog, publishes the most consistent and detailed information, and can serve as a reasonable proxy for the industry.
Between September 2005 and September 2008, Fluor’s reported backlog of oil and gas projects quadrupled from $5.2 billion to $22.8 billion, driven by surging demand for exploration and refining, as well as soaring inflation in the cost of the projects themselves (Chart 1).
Fluor’s profit margin climbed from 4.6 percent to 5.6 percent, and briefly touched an extraordinary 6.2 percent in the third quarter of 2008. Operating profit tripled from $242 million in calendar 2005 to $724 million in 2008, according to the company, as the oil and gas industry scrambled to respond to rising prices.
Soaring demand and profit margins in turn drove a peak in engineering companies share prices in 2007-2008 (Chart 2).
Chart 1: link.reuters.com/nyv72v
Chart 2: link.reuters.com/qyv72v
Backlogs were reduced briefly during 2009 and the first six months of 2010 as a result of the financial crisis, which caused a hiatus in oil and gas investment, but swiftly rebounded, reaching $19.5 billion by the end of June 2012, just $3 billion below their previous peak.
In the last 12 months, however, the backlog has shrunk. By the end of June 2013, Fluor reported the backlog of oil and gas work was down to $18.7 billion.
KBR, another large engineering company with a lot of oil and gas work, also reported its backlog of hydrocarbons projects was down, from $9.4 billion to $8.7 billion, over the same period.
By contrast, Foster Wheeler saw its oil and gas backlog rise from $2.2 billion to $2.7 billion. But the company admitted the “competitive environment remains challenging, with commercially aggressive bidding as the norm.” Bid invitations and contract award dates continue to slip, the company added.
The slowdown has been even more pronounced in mineral-related projects, where mining companies have cancelled or postponed projects in response to lower prices for iron ore, coal, copper and other metals.
In the most recent quarter, Fluor’s margin on oil and gas projects was just 3.74 percent, a small improvement on 2012 and 2011 when profit touched just 3.3 percent, but down by more than 60 percent from the highs recorded in 2008.
If the engineering and construction sector is a leading indicator for future oil and gas production, refining and transportation, it is signalling comfortable increases in supply for the remainder of the decade. (Editing by David Evans)