The document discusses the rising costs and risks associated with large-scale capital projects in the energy sector. It outlines challenges facing the energy industry, including price volatility, rising project costs and delays. Accurate cost estimates are important for decision making, but estimates often do not adequately assess project risks and uncertainties, which can lead to cost overruns. The document emphasizes that identifying and quantifying risks early through cost risk analysis and benchmarking can improve decision making and minimize negative impacts.
A.Sanchez_The rising cost and risks of large-scale capital projects
1. THE RISING COST AND RISKS OF
LARGE-SCALE CAPITAL PROJECTS
IN THE ENERGY SECTOR
Alberto Sanchez
January 2017
2. Alberto Sanchez
BEng, MsCLog, MIntBus, GradCertEnSt
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2
Alberto has over 20 years of experience delivering capital
projects with values from $100 million to over $10 billion in
Asia-Pacific, Middle East, Europe and Central Asia and Latin
America in the private and public sector. He has worked
across different industries including oil and gas, chemicals,
utilities and infrastructure throughout all project phases
(feasibility studies through to commissioning) as project
controls manager, head of project controls, planning
manager and head of capital projects for international oil
companies, E&C contractors and consulting firms
Alberto holds a bachelor degree in civil engineering, master degree in
logistics and operations, master degree in business and postgraduate in
energy studies from recognised Australian universities. He is often requested
as a keynote speaker at major companies and industry conferences
worldwide on planning/scheduling, risk management and modular
construction.
He is always interested in hearing from former colleagues, clients, or just
interesting folk, so feel free to contact him
3. Contents
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Main objectives
Project economic feasibility
Challenges facing the energy sector
Cost estimates and decision making
Cost optimisation opportunities
Project risks and uncertainties
Cost benchmarking
Cost estimate assurance
Major causes of cost overruns
Conclusion and recommendations
4. Main objectives
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Understand the major challenges facing the energy
sector
Understand the relation between accurate cost
estimates and quality decision making
Understand the opportunities of cost reduction
during the project lifecycle
Estimate the project risks and cost uncertainties
Identify the major cost risks and opportunities
5. Project economic feasibility
The feasibility and
approval of a new
capital project requires
the gathering of
essential information
Each of those pieces of
information has inherent
risks and uncertainties
that can have impact to
the decision outcome
Capital expenditure (CapEx)
Operating expenses (OpEx)
Estimated production profiles
Concession terms
Fiscal (tax) structures
Estimated commodity prices
Project schedule
Stakeholders’ expectations
5
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6. Challenges facing the energy sector
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The energy sector has always been seen as a high-
risk / high-reward business
Yet, risk factors such as price volatility, geopolitics,
regulatory climate, etc. have become more difficult
to manage
Commodity price fluctuations are nowadays more
related to macroeconomic and political factors than
supply and demand factors
7. Challenges facing the energy sector
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•Projects are more complex
and risky due to the uncertain
global socio-economic
environment (e.g. political
climate, resource nationalism,
security risks, trade and
financial sanctions, etc.)
Geopolitical
environment
•Price distortions among regions
caused by supply chain
constraints creating arbitrage
opportunities (e.g. political
tensions or other speculative
factors)
Prices volatility
•Rising project costs have
played an important role in
the decline of energy projects
profitability; large number of
capital projects are facing cost
overruns and/or delays
Rising costs
and delays
•Investments in regions without
mature legal or regulatory
frameworks (e.g. unrealistic
local content, ambiguous
project approvals, government
price vulnerability)
Regulatory
climate
•Delay building or revamping
infrastructures outside project
scope causing bottlenecks in
construction or production (e.g.
inadequate export pipeline,
unreliable power supplies,
constrained port terminal, etc.)
Infrastructure
dependency
•After years of sustained high
commodity prices some
projects have dropped
significantly outside the
acceptable threshold of returns
required by shareholders
Project
financial
performance
8. Challenges facing the energy sector
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As a result, now more than ever energy companies
carefully select the projects to invest in order to
ensure the expected return on capital and
ultimately shareholder return
Yet, cost overruns are becoming increasingly
common for large energy development projects
Many times the cause of the problem can be traced
back to inaccurate cost estimates and insufficient
risk assessment during the early project life cycle,
leading to subsequent cost growth
9. Cost estimates and decision making
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The accuracy of the cost estimate is critical for
decision-makers to choose whether or not to proceed
to the next phase of the project
Over-estimate can lead to decisions
to terminate an economic project (or
lucrative business opportunity)
Under-estimate can lead to
significant cost and schedule overruns
and in some cases costly decisions to
terminate the project in a late-stage
10. Cost estimates and decision making
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Key factors to consider when developing a cost
estimate :
Understand the purpose of
the cost estimate (e.g.
feasibility, budget
authorization, control, etc.)
Understand the level of
project definition to provide
the level of accuracy of the
cost estimate (e.g. -10% to
+20%)
Understand the quality of the
project information available
during the cost estimate
Understand the cost
estimating capability
available within the
organisation in terms of
processes, resources and tools
Understand and estimate the
cost impact ranges from risks,
uncertainties and
opportunities
Understand the cost estimate
is one of the most important
pieces of information to
determine the economic
feasibility of the project and
approval to proceed to the
next project phase
11. Cost estimates and decision making
AACE Cost Estimation Classification
11
PHASE 1
Identify
PHASE 2
Select
PHASE 3
Define
PHASE 4
Execute
PHASE 5
Operate
ESTIMATE CLASS Class 5 Class 4 Class 3 Class 2 Class 1
LEVEL OF PROJECT
DEFINITION
DELIVERABLES
0% to 2% 1% to 15% 10% to 40%
30% to
75%
65% to
100%
END USAGE
Typical purpose of estimate
Concept
screening
Study or
feasibility
Budget
authorisation
or control
Control or
bid/tender
Check
estimate (on
actual costs)
METHODOLOGY
Typical estimating method
Capacity factored,
parametric models,
judgment, or analogy
Equipment
factored or
parametric
models
Semi-detailed unit
costs with
assembly level
line items
Detailed unit
cost with forced
detailed take-
off
Detailed unit cost
with detailed
take-off
EXPECTED ACCURACY
RANGE
Typical variation in low and
high ranges
L: -20% to -50%
H: +30% to +100%
L: -15% to -30%
H:+20% to
+50%
L: -10% to -20%
H: +10% to
+30%
L: -5% to -15%
H:+5% to
+20%
L: -3% to -10%
H:+3% to +15%
DG1 DG2 DG3 DG4
Decision Gate
12. Cost optimisation opportunities
12
Establish preliminary
scope and business
strategy
Establish development
options and execution
strategy
Finalise scope and
execution plan
Detail and construct
asset
Operate, maintain and
improve asset
DG1 DG2 DG3 DG4
Major
Influence
Rapidly
decreasing
influence
Low
Influence
High
Low
Large
Small
Expenditures
Influenceovercosts
Expenditures
Influence
Uncertainties
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The graph shows the importance of making the right
decisions early in the project lifecycle
There is a clear link between
decreasing ability to influence project
costs and increasing maturity of the
project in the lifecycle
13. Project risks and uncertainties
FID = Final Investment Decision
13
Projectedfinancialperformance
(NPV,ROI,IRR)
Hurdle rate
Minimising the negative
impact of project cost growth
Achieving the
expected hurdle rate
Establish preliminary
scope and business
strategy
Establish development
options and execution
strategy
Finalise scope and
execution plan
Detail and construct
asset
Operate, maintain and
improve asset
Hurdle Rate:
the minimum
rate of
return on a
capital
project
required by
the
shareholders
Minimising
negative
impact: The
effort by the
company to
reduce costs
and/or
reduce the
risk impacts
(e.g. cost
overruns,
delays)
• Several projects report cost overruns compared to the approved cost
estimate (authorised budget) resulting in poor economic results
• Early cost estimates may not adequately assess the project risks and
uncertainties causing potential cost growth
DG1 DG2 DG3 DG4
Project Sanction/FID Gate
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14. Project risks and uncertainties
As the project moves through the project phase gates,
risks should be formally assessed to determine the
likelihood of achieving the expected return on capital
and ultimately shareholder return
The use of appropriate processes and tools to identify
and quantify project risks and uncertainties can help
decision-makers to decide whether the project is ready
to proceed to the next phase
Project cost risk analyses can help to assess the level of
accuracy of the cost estimates and make better
informed decisions
14
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15. Project risks and uncertainties
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Example:
Final location of the proposed new facility
Local or regional market conditions
Availability of qualified E&C contractors
Increase of original estimated quantities
Availability of skilled workforce
Expected productivity of workforce
Changes to local content requirements
Availability of specialised construction equipment
Closure of preferred route for heavy and oversize vehicles
Extreme weather conditions
Others
16. Project risks and uncertainties
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Cost risk analysis and benchmarking can improve
considerably the quality of the decision-making
process
Frame the capital
investment
decision (e.g.
strategy, project
targets,
shareholders’
expectations)
Identify the
project risks and
uncertainties (e.g.
market conditions,
material prices,
etc.)
Quantify the
project risks and
uncertainties (e.g.
project cost
ranges,
probability
distributions)
Benchmark and
compare the
proposed new
facility to
historical project
costs (e.g.
$/tonnes/year)
Better
Decision-
Making
17. Example: Process Plant in Europe
The cost risk analysis shows that
the project is unlikely to meet the
anticipated capital cost (CapEx)
of $1.40 billion
There is a probability that the
project will be $400MM to
$600MM higher than the
anticipated capital cost
If the minimum return on capital
can be met despite potential
higher capital cost then decision-
makers can choose to proceed to
the next phase of the project
17
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$1,500,000,000 $2,000,000,000
Distribution (start of interval)
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
Hits
0% $1,459,692,915
5% $1,594,554,808
10% $1,633,003,564
15% $1,671,631,159
20% $1,702,343,433
25% $1,737,849,722
30% $1,765,688,623
35% $1,785,516,891
40% $1,802,065,862
45% $1,820,707,140
50% $1,843,753,414
55% $1,859,762,710
60% $1,877,174,383
65% $1,898,244,014
70% $1,911,301,973
75% $1,926,764,697
80% $1,947,126,710
85% $1,969,288,577
90% $1,999,687,047
95% $2,046,326,210
100% $2,191,720,516
CumulativeFrequency
Example: Process Plant in Central Europe
Cost Risk Analysis
Anticipated capital cost (CapEx) = $ 1.40 billion
18. Example: Process Plant in Europe
18
Major project risks
5%
7%
7%
9%
13%
16%
16%
21%
23%
28%26 - Delay in construction due to changes during detailed design
22 - Changes during the incorporation of optimisations in the detailed design
20 - Major changes to basic design parameters
25 - Delay in approval of E&C contractor selection by stakeholders
24 - Rejection of technical options during detailed design reviews
10 - Shortage of qualified personnel to manage the project
15 - Poor management and integration of subcontractor(s)
40 - Change in local regulations for imported goods
55 - Lost Time Incident (LTI) due to lack of safety culture by local subcontractors or workers
30 - Design changes after placement of purchase order(s)
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19. Cost Benchmarking
Benchmarking has long
been used to improve
the accuracy of project
performance
It is the process of
comparing the estimated
capital costs of the
proposed new facility
against the results of
similar projects in the
industry
19
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PROJECT COST
ESTIMATE REPORT
DEVELOP COST
METRICS
COST DATA
COLLECTION
SYSTEM
COMPANY
PROJECTS
(INTERNAL)
SIMILAR
PROJECTS/
NORMS
(EXTERNAL)
CONDUCT COST
BENCHMARK
COMPARISON
VALIDATE COST
ESTIMATE
20. Example: Process Plant in Europe
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20
The following analysis is based on a cost database
including actual information of similar process plants
completed by the company
Proposed new facility :
Capacity = 8 billion m3 per year
Benchmark project:
Capacity = 9 billion m3 per year
21. Example: Process Plant in Europe
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21
The anticipated cost estimate is about 23% below the benchmark and
The worst case scenario (P90) is about 12% above the benchmark
The most likely scenario (P50) against the results of similar projects are very
close and meets the minimum return on capital for decision-makers to
proceed to the next phase of the project
Cap Benchmark
Cost Estimate Scenario Cost Estimate
Original
Scenario
P50
Scenario
P90
Scenario
Using benchmark
values
Benchmark project
9 billion m3 per
year
$ 2.20
billion
$ 1.40
billion
$ 1.84
billion
$1.99
billion
$ 1.82
billion
Proposed new facility
8 billion m3 per
year
Delta versus
benchmark values
≈ -23% ≈ +1% ≈ +12% 1 (base)
Anticipated capital cost (CapEx) = $ 1.40 billion
22. Cost estimate assurance
22
Most companies perform a “cost assurance review” as part of the
project gates
The aim is to produce an independent review of the confidence level
of the cost estimate of the proposed new facility
This often becomes a basis for authorisation to move to the next
project phase (e.g. execution phase)
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PHASE 1
Identify
PHASE 2
Select
PHASE 3
Define
PHASE 4
Execute
PHASE 5
Operate
ESTIMATE CLASS Class 5 Class 4 Class 3 Class 2 Class 1
LEVEL OF PROJECT
DEFINITION
DELIVERABLES
0% to 2% 1% to 15% 10% to 40%
30% to
75%
65% to
100%
END USAGE
Typical purpose of estimate
Concept
screening
Study or
feasibility
Budget
authorisation
or control
Control or
bid/tender
Check
estimate (on
actual costs)
DG1 DG2 DG3 DG4
Cost estimate assurance
23. Cost estimate assurance
23
PROJECTTEAM
PROJECTCOST
ESTIMATETEAM
COSTASSURANCETEAM
THIRD
PARTY
(ifapplicable)
* COST ESTIMATE
REPORT
* TECHNICAL
DOCUMENTATION
COST ESTIMATE
REVIEW REQUEST
COST BENCHMARK REVIEW:
* UNIT COST RATES
* LABOT COST RATES
* PRODUCTIVITY RATES
* COST RATIOS OR RANGES FOR:
* INDIRECT COSTS
* FREIGHT
* INSURANCES
* VENDOR ASSISTANCE
* COMMISSIONING
COST ESTIMATE
WITHIN INDUSTRY
NORMs and/or
ESTIMATE
EXPECTATION?
ACCEPT PROJECT
COST ESTIMATE
YES
* PREPARE INDEPENDENT
COST ESTIMATE FOR COST
COMPARISON
* IDENTIFY AREAS OF COST
IMPROVEMENT
* ESTIMATE COST OF
TECHNICAL OPTIMIZATION
RECOMMENDATIONS
NO
IDENTIFY AREAS OF
TECHNICAL
OPTIMISATIONS
REVIEW AND UPDATE
COST ESTIMATE REPORT
PREPARE OFFICIAL LETTER
WITH COST ESTIMATE
REVIEW COMMENTS &
AGREED TECHNICAL
OPTIMISATION
RECOMMENDATIONS
PREPARE INDEPENDENT
COST BENCHMARK REVIEW
ANALYSIS REPORT
FINAL COST ESTIMATE
COMPARISON REVIEW
COST ESTIMATE
WITHIN INDUSTRY
NORMs and/or
ESTIMATE
EXPECTATION?
ACCEPT PROJECT
COST ESTIMATE
YES
NO
* DECREASE SCOPE
* DEFER CAPEX
* SIMPLIFY FACILITY
* CONSIDER ALTERNATIVE
STANDARDS
* CONSIDER ALTERNATIVE
CONTRACT STRATEGY
* CONSIDER ALTERNATIVE
CONSTRUCTION METHODS
* OTHERS
JOINT REVIEW OF
TECHNICAL
OPTIMISATIONS
IDENTIFY AREAS OF
TECHNICAL
OPTIMISATIONS
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24. Major causes of cost overruns
Wrong contract strategy
Wrong selection of
contractor(s)
Wrong construction method
Incomplete design at the time
of bidding E&C
Design errors and omissions
Scope changes and/or late
modifications
Poor planning and interface
Late equipment deliveries
Inaccurate cost estimates
Schedule-too-optimistic
Poor productivity
Regulatory changes
Late decisions (price
fluctuations)
Project deferred
Interface with other projects
Lack of experience
Others…
24
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25. Conclusion and recommendations
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25
Inaccurate project costs can lead to incorrect
decisions
Inaccurate estimates can result in inefficient use of
resources and late projects
Clear cost expectations in the early phases of the
project is crucial
Ignoring a risk will not eliminate its potential impact
Used correctly, benchmarking can add value to the
project by improving accuracy of the project cost
estimate
26. THE RISING COST AND RISKS OF
LARGE-SCALE CAPITAL PROJECTS
IN THE ENERGY SECTOR
Contact:
amsanchezu@gmail.com