Haste has its price

Side-16
26.06.2013
Petter Osmundsen, professor of petroleum economics at the University of Stavanger, reviews experience with and sheds light on the economic consequences of over-hasty project execution.
  • Illustration: Anette Moi

Norwegian offshore investment goes up and down. At regular intervals, high oil prices cause activity to pile up and lead to associated cost-overruns and delays.

One of these boom periods is currently under way, and the negative effects are being felt even before spending has peaked. A look at past experience could therefore be instructive.

A plan for development and operation (PDO) of a Norwegian offshore field must be accomp-anied by socio-economic analyses when submitted to the government for approval.

These assessments include considerations related to the utilisation of existing infrastructure and coordination of fields as well as business aspects.

Oil company representatives have no problem personally admitting that everyone would benefit from a more stable pace of development.

That would secure good quality while avoiding sharp cost increases and delays. More sequential awarding of contracts would also ensure a higher Norwegian share of deliveries.

But everyone also insists that their own projects must be allowed to proceed, while those of the other companies are held back.

The market solution accord-ingly yields a pile-up of activity, with all the challenges that this represents. Since a planned approach creates at least equally substantial problems, it is usually not regarded as an alternative.

Are such great investment collisions inevitable? Are they rational? Questions can be raised about many economic aspects related to project pile-ups and hasty development.

Inadequate tailoring of production equipment, cost overruns, delays and quality challenges are highly relevant in economic terms.

A development with lots of parallel work can easily look good on the spreadsheet, since value will rise if revenues start to flow earlier.

In practice, however, these decisions are often taken on unstable foundations and lead on to both overruns and delays. Haste has its price.

 

Overruns

Spending estimates were exceeded in a number of NCS developments during the 1990s, with such overruns topping NOK 30 billion or 27 per cent in 13 projects analysed by an official investment inquiry (Norway’s Official Reports 1999:11).

This study noted that the developments concerned were characterised by short implemen-tation times both before and during project execution.

“[That] has meant a big overlap between the various phases [of] design, construction and commissioning,” the report states. “This has led to a growing risk that an error/change in one phase will mean delays and increased costs in the next.

“It has also limited the oppor-tunity to overcome unforeseen problems in one phase without knock-on effects for the next. Changes in project conditions have accordingly had big consequences for execution.”

A key recommendation from the inquiry was more quality at an early stage. “A general feature of the projects studied in greater detail by the commission is that the decision base was weak when the development was launched and the PDO approved.

“The commission believes that a potential for substantial improvement exists here, and recommends measures ... to improve the decision base in future projects.”

In its view, projects should be developed to such a stage that the cost of the various development components can be estimated with reasonable certainty before the PDO is approved.

This corresponds with inter-national advice, which itself reflects the fact that 65 per cent of megaprojects around the world fail to meet their targets.

Independent Project Analysis Inc (IPA) offers the following advice for project execution:

  1. preparation is crucial (or you are working blind)
  2. establish realistic budgets and timetables (optimism is not a project virtue)
  3. make goals clear and consistent (avoid ambiguities)
  4. seek continuity in staffing (particularly in key roles)
  5. do not be afraid to slow down (the desire to advance too quickly, particularly in the planning phase, is one of the commonest reasons for a fiasco).

 

Recognition

The overruns of the 1990s led to broad industry recognition that more time should be spent maturing what was known about reservoir size and drainage strategy before choosing a development concept.

Technical concepts should also be sufficiently well developed before construction begins – again to secure a better basis for a high recovery factor. That also yields a better contractual basis and consequently a clearer division of responsibilities.

Haste generally puts the developer in a weak negotiating position. They must also pay to get further up the queue for certain critical deliveries.

A more mature concept means that the design can be frozen to a greater extent, and the developer avoids expenditure on re-engine-ering and refabrication.

Signs can be seen in the present NCS boom that some of these lessons have been forgotten, and it is unclear whether companies are taking the time to mature projects properly.

This is particularly worrying because many of the major contracts have been awarded to foreign yards which are not good – by the oil companies’ own admission – at handling changes.

The operators have accordingly emphasised that freezing the design will be crucial. That makes it even more important to mature projects adequately.

If the companies are too busy at the start of a project, they often end up making changes along the way – and these lead in turn to delays and higher bills.

Tenders from yards which have no experience of Norwegian standards thereby become a bigger risk than ones submitted by fabricators who possess such knowledge.

Statements from various oil companies suggest that they price this consideration differently from each other during the bid evalu-ation process.

That could reflect differing assessments of the need for follow-up, or variations between the oil companies in expertise on and capacity for exercising such supervision.

Economic analysis is concerned with flexibility on the income side, which can be priced with the aid of options. As a project continues, the developer often acquires new reservoir data which could call for adjustments to ensure the best possible recovery.

A greater degree of flexibility in project execution, of the kind offered by Norwegian yards, accordingly has a value in the form of improved resource economics. The ability of these fabricators to handle special designs may also yield better resource utilisation.

The question is whether such income options are being taken into account in bid evaluations or whether the developer’s primary interest lies on the cost side.

In this context, flexibility must be balanced against the anticipated extra price tag. The cost differential may be too large in many cases, and possible delays and overruns at Norwegian yards must be taken into account as well.

 

Management

Distinguishing between Norwegian and foreign bidders may also be a bit superficial, since “domestic” yards often include a large proportion of work abroad in their bids. An important distinction is who will be responsible for project management.

Preserving the kind of expertise on managing major developments possessed by Norwegian turnkey contractors today is important for Norway’s petroleum cluster. That also applies to the oil companies which use their suppliers as a recruitment base.

Good plans are not enough. Launching a project without competent suppliers who have adequate capacity, and without sufficient in-house resources for supervision, may backfire.

Supervising developments requires the operator to have built up control systems. Competent individuals are not enough. Sufficient human resources to follow up projects represents a challenge for oil companies new and old, large and small.

An operator like Hydro – since absorbed by Statoil – was known for good project control but also suffered big cost overruns in the 1990s when the number of developments suddenly expanded.

One problem was that it lacked enough competent project personnel to follow up such a large portfolio. That evokes parallels with today’s position on the NCS.

It is widely believed that a developer must exercise direct supervision of suppliers who are new to the NCS. But Statoil clearly disagrees with this view.

“We devote some seven to 10 per cent of costs to follow-up,” Anders Opedal, senior vice president for projects at the state-dominated company, told a technical journal on 21 February.

“If we build at Stord [north of Stavanger], we must have people commuting there. The same applies for Korea. We do not envisage a larger team of engineers at the latter than at the former.”

Such comments are not reassuring when the scope of addi- tional work required on facilities delivered to the NCS from Asia and other regions is taken into account. Much depends on previous experience with Norwegian requirements.

Information on the proportion of spending devoted to supervision is interesting. Combined with applicable investment plans, this makes it possible to calculate the resources which will be applied to follow-up.

By making assumptions on pay, this can be converted into work-years. A rough estimate for the NCS as a whole suggests NOK 40 billion in investment for 2013 and annual per capita pay of NOK 1 million.

Assuming that seven per cent of the costs take the form of follow-up, this means that such activities alone represent 2 800 work-years.

Various assumptions can be made here, and pay undoubtedly represents only part of the bill for supervision. Nevertheless, this calculation illustrates a big need for follow-up.

The question is whether Norway really has so many experienced and competent people for this type of work. While the world has become global, that does not always apply to labour.

How many Norwegians with experience and expertise of technical supervision and project management want to commute to Asia, for example, over several years?

This simple calculation also indicates that developers will need even more people to follow up in the event of expenditure overruns.

 

Cycle

Once costs do increase, a vicious cycle becomes established. Experience shows that completing an out-of-control project demands a lot more resources and personnel than one still on target.

Delays or additional follow-up can also have a knock-on effect on other developments in the portfolio. Additional resources must be allocated to the overrunning project, squeezing capacity and attention which should have benefited new ventures.

It is important to remember in this context that supervising a sharply growing development portfolio on the NCS comes on top of a greatly increased need to follow up extensive and complex investment in producing fields.

Similar demands are made by the 15 additional rigs due to be delivered to these waters. Licensees are considering owning some of these directly, which will also boost supervisory needs.

Finally, the staffing calculation must take account of new players on the NCS who will be accepting responsibility for major developments. These must allocate a number of work-years to controlling activities in fields operated by partners.

The overall need for follow-up must be viewed in relation to capacity, but the challenge is that it takes many years to train people up for such jobs.

 

Expertise

Petroleum investment on the NCS is growing very sharply at present, and much faster than the ability of the companies to build expertise. Many trends are similar to those seen in the 1990s, which resulted in major cost overruns and delays.

In all probability, the oil companies would benefit from a lower level of activity to ensure that projects are adequately matured and that the necessary expertise is available.

Execution strategies should be shaped to ensure that the need for supervision is in line with the companies’ capacity to provide it.

Since the drawbacks of over-hasty project execution are well known to the industry, it is timely to ask whether its attention is focused now on production volume rather than value creation.

The idea must be that investors give strong weight to growth in their valuation models. But they cannot live by expansion alone, and oil companies could risk underestimating them here.

Investors see right through analysts’ fancy performance figures. They understand that the oil industry is very long term and demands a balanced, far-sighted strategy to create value.

The problem with analyst figures is that they are incomplete and that they change in line with the fashion of the day.

To provide any guidance, performance figures must at least be ahead of the trends. Volume has been fashionable at a time of high oil prices, but the market is now worried about high capital exposure in oil companies as a result of overheating.

The performance figure attracting ever greater attention is “free cash flow”. Many large and parallel developments do badly by this measure, with overruns and delays completely disastrous.

 

"A greater degree of flexibility in project execution, of the kind offered by Norwegian yards, accordingly has a value in the form of improved resource economics"