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Oil and gas firms combat falling yields with contractual risk management

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World Pipelines,

Shrinking margins and declining return on assets makes capital discipline excellence essential for owner operators of large capital projects. Delivering verifiable discipline in such projects provides a commercial firewall against value leakage from unmanaged changes, contractor claims and unrecoverable costs says 8over8’s Clare Colhoun.

Integrated oil and gas majors face common threats: shrinking operating margins, declining production, and declining return. Several majors issued profit warnings ahead of Q1 2014 results.

The decline in return has caused shareholder and investor dismay. Analysts warned that ‘fears over capital discipline’ were significant in the underperformance of the global oil and gas sector. Yet firms have been slow to respond, and few have been left wondering why the downward trend is so pronounced.

Energy companies must adjust their expectations for profits in order to make the investments needed for future energy demand, the International Energy Agency (IEA) warns.

The IEA’s Chief Economist, Fatih Birol, said: “Companies have to improve their capital discipline and they have to be a bit more realistic in the future about rates of return, so long as prices remain at these levels.”

The easy oil is gone, hydrocarbons are harder and more expensive to extract, and the largest capital projects are increasingly complex and unpredictable.

At the commercial interface

Change is a given in oil and gas projects. The best design team that produces the front-end engineering design (FEED) will never conceive of everything that is required to deliver a successful project. Therefore, contractors will always instigate change orders.

The approvals and impact of change requests that are buried in communications from contractors take time to filter through to the financial teams of owner operators. These can fester to significant levels that result in costly claims later on, when it is harder to establish the origin and validity of the changes.

According to a report by McKinsey late last year, the key risks during project execution are related to contractual default, claims, keeping public political stakeholders aligned, and monitoring for contractor mismanagement. Contractor communication is therefore the critical element.

Former CEO of Schlumberger, Ian Gould (and now Interim Executive Chairman of BG Group) stated that 35% of capital projects budgeted at over US$ 5 billion will blow out by more than 50% whilst speaking at the GES Summit 2013. This cannot be understated: the average project size in the industry currently stands at about US$ 1.9 billion and continues to rise as more ‘super-sized’ projects come online. Several are averaging between US$ 30 – 50 billion plus, with Kazakhstan’s Kashagan oilfield reaching US$ 115 billion having suffered significant delays and cost overruns.

The DNA of contractual risk management

Contractual risk management ensures that chaotic communications that exist on large capital projects are streamlined and controlled – whether about an instruction, an obligation, potential change, or site query.

Imagine that time is represented by a horizontal axis. Capital is deployed in increasing amounts as construction of the project progresses over time. That capital is deployed via contracts, but without a system of engagement that ensures a disciplined way of communicating with contractors and managing the risk inherent within those contracts, the entire process is open to costly ambiguity.

Now imagine the application of contractual risk management is a coil around the project timeline. This coil is a system of record. It aggregates all communications across the timeline. Here, communication becomes structured under specific categories. Crucially, the timeline and the coil are intertwined, much like a DNA sequence, to provide an indisputable record of all formal contract data, communications, obligations, review decisions and decision response times.

By accessing irrefutable evidence in this ‘DNA sequence’, owner operators can reduce instances of claims and maximise cost recovery to ensure all project and contract stakeholders bear their appropriate share of legitimate unplanned costs.

Early warning and proactive risk management

By applying analytics to a single system of engagement and record, with disciplined and structured communications, owner operators can start to act on business intelligence. For example, if a contractor sends a variation order request on a major project which has a significant value associated with it, that communication can be routed to those that need to see it and, more importantly, to those that need to take the decision on whether or not to approve it.

Owner operators can also measure the riskiness of particular projects. Should large volumes of variation requests come in over a short period of time, appropriate stakeholders will be notified that scope is a problem and as such the project is at risk. Action can then be taken to avert significant value leakage and scheduling overruns in commercial relationships with contractors, which current in-house systems are simply unable to achieve.

Contractual risk management solutions integrate fully with other enterprise systems and bring a disciplined approach to all communications between project partners and contractors by:

  • Instructing contractors, partners and stakeholders to communicate through one channel in a pre-defined, organised way.
  • Connecting the engineering world with the commercial world by insisting all technical queries, instructions and otherwise are routed through the commercial channel for review, checking alignment or disparity with the contract, and then to the contractor and owner operator’s technical teams.
  • Gaining significant and valuable insights by analysing the commercial communication traffic that highlights priority areas of the engagement that need attention. These early warning indicators (EWIs) allow owner operators to accept changes and avoid unnecessary changes that can result in claims.

Predictable outcomes

Several of the largest supermajors, majors and independents are changing the way they manage change in the execution of their capital project contracts. What’s more, they are generating significant savings.

An oil major recently completed a US$ 12 billion mega project with zero successful contractor claims. In other words, not one dispute or unapproved variation was accepted. Such a triumph was previously unheard of in the oil and gas industry. One independent has even deployed a contractual risk management solution based on recovering US$ 1 million daily in enhanced cost recovery.

Ultimately, by managing key contractual risks, owner operators benefit from connected decision-making through improved capital discipline, and therefore realise a much more predictable commercial outcome.

Written by Claire Colhoun, CEO of 8over8.

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