Due to the dynamic nature of the oil and gas industry, many factors force companies into signing agreements such as engineering, procurement, construction (EPC) contracts. Any delay or inefficiency in these contracts can have a devastating impact. Thus, ideal contract strategy is of paramount importance to avoid deviation from the project schedule or budget to reap the maximum benefit for companies. Unsurprisingly, contract strategy is at the forefront of oil and gas companies’ agenda.
Contract strategy is discussed in a paper titled Evaluation of an OBCE Conversion Contract in a Large-scale Oil and Gas Project. The study, which is written by Ruveyda Komurlu, Associate Professor at Kocaeli University, and Akin Er, General Management at Turkey’s oil refining company TUPRAS, seeks to offer a unique analysis on contract strategy by evaluating the successes and failures of EPC contracts. Defined by the organizational and contractual policies, contract strategies are selected for the execution of a specific project. This paper maintains that contract strategy is one of the key parameters which has significant effects on the project.
Overview of Contract Strategy
Contract strategy shapes the management decisions of all parties in the project. It is dependent on three main components: project delivery method, contract price arrangement, and contract clauses.
Project delivery method divides up the responsibilities of each project phase between the respective parties of the contract and can be compartmentalized into Design-Bid-Build, EPC, Construction Management (CM), and Relational Contracting Model (RCM). These contract methodologies are rigid in their procurement apart from RCM which offers greater contract flexibility dependent on the other party’s objectives.
Secondly, contract price management can be split into three parts: Price Based Contracts (PBC) determines all prices of the project but costs remain unknown to anyone but the owner. Secondly, in Cost Based Contracts (CBC) the contractor is reimbursed for all costs plus fee and all costs are known. Lastly, Guaranteed Maximum Price Contracts (GMPC) is a combination of price and cost-based contracts whereby the contractor is entitled to be reimbursed up to a maximum fixed amount.
Finally, contract clauses principally adjust general responsibilities of parties during the execution of the project. The majority of contract clauses cover basic project matters such as reference documents, penalties, and bonuses. However, clauses should be tailored to specific projects taking into account the company’s own contract strategy.
Large-Scale Oil & Gas Project Contracts
A large-scale oil and gas project begins with idea generation (project maturity) and ends with an operational start-up (implementation of project). At the end of the project maturity, project cost estimates are updated and investment feasibilities will be reassessed.
Generally, the execution stage of the project takes the form of EPC. Due to the costly nature of downtime in the oil and gas industry, there is an extra incentive to speed up the execution period. Therefore, large-scale oil and gas projects are usually fast-tracked by means of overlapping the different stages of the EPC.
Accuracy of Capital Expenditure (CAPEX) is another important aspect in these projects. CAPEX directly affects the financial parameters of the investment and has a significant role when it comes to the investment decision. The AACE Cost Estimate Classification is used to calculate the CAPEX before commencing the project execution. Its corresponding accuracy ranges regarding the maturity level of project deliverables.
EPC Contracting Methodologies
It is widely accepted that EPC contracts are the most advantageous strategy for the owners because they ensure the most reliable budget, minimum risk levels, and allow fast-track execution. Needless to say, EPC contracts do come with disadvantages such as maximum contingency in the contract price and less involvement of the owner in the detailed design phase.
Owners may prefer to award the EPC contract directly. Alternatively, they could have a front-end engineering design (FEED) study done first and award the EPC contract afterwards. Owners could also set up a Convertible Contract and convert it to EPC after an open book cost estimate process. The last two methodologies have been developed to minimize the disadvantages of EPC contracting.
In the case of a direct EPC contracting, the owner defines the project frame and assigns a contractor to follow all EPC activities. However, the contractor bears the risks and responsibilities. Therefore, the contract price includes a maximum contingency. A way to counter this is to have a FEED contract first and award the EPC contract afterwards. This way, design development will reach a reasonable level of maturity before an EPC contract is awarded. Furthermore, this allows project cost to be estimated more precisely as cost deviation is inversely proportional to the level of information.
In order to prevent the discontinuity of joint FEED and EPC contracts, one can introduce a convertible contract where the owner and the contractor agree on a two-stage contract. Firstly, detailed design is advanced up to a certain level where project cost can be calculated accurately by using an Open Book Cost Estimate (OBCE). This is the crucial element in a convertible contract because it allows the contractor to be paid in any price adjustment structure. The second part of the contract is then converted into an EPC lump sum. This technique benefits the owner by knowing all project costs upfront, the contingency amount, and also the contractor’s profit.
The research concludes that OBCE convertible contracts allow the owner to optimize the combination of important project parameters such as initial cost, change order ratio, duration of the project, and management organization. Because of this, they are the most favored contract type in the oil and gas sector due to the contract’s ability to adapt to the dynamic and complex nature of the sector.