Managing Capital Project Financial Risk Through Analytics

Managing Capital Project Financial Risk through Analytics Summary: Oil and Gas capital project costs are becoming increasingly difficult to manage. This white paper analyzes the reasons behind the challenges faced by the industry and provides a proactive approach to assuring capital projects against unplanned costs - by implementing a Projects Business Intelligence Solution (PBIS). A PBIS could help save more than $15M for a typical Offshore capital project by providing early visibility into future spend and schedule changes through historical and predictive analytics. It could provide the capital project teams with a decision support capability to develop strategies well in advance to address any emerging financial risks that are likely to manifest. Written by Swami Ranganathan, December 2014 Managing Capital Project Financial Risk through Analytics 1

Financial risks have Capital Project Cost Capital project could experience never been greater cost overruns due to several for Oil and Gas capital Oil and Gas operators are reasons: 1) scope changes, 2) projects involving developing increasingly complex design & specification changes to construction and mega projects to meet the energy address engineering challenges, commissioning of demands across the world. The 3) material & labor cost offshore platforms, financial risks have never been escalations, 4) schedule LNG terminals, greater for these projects acceleration, delay or cancellation Floating Production, involving construction and by project teams, 5) delays in sub- Storage and commissioning of offshore system construction by Offloading (FPSO) platforms, LNG terminals, Floating contractors, 6) vessels, and onshore Production, Storage and installation/transport vessel pipelines Offloading (FPSO) vessels, and availability, mobilization and onshore pipelines, due to their demobilization etc.,. Chart 1 higher forecasted budgets and shows one such case of a cost longer timelines to complete. With overrun in a capital project 64% of such projects having cost fabrication work by a contractor overruns according to a recent for a super major operator. In this consulting firm study of 365 mega case, the cost was found to exceed projects1, project cost the budget by 25% resulting in performance has become a very over $300M in additional expenses important issue for the industry as for the fabrication work alone with a whole. knock-on effects on other project deliverables. Chart 1: Forecast Versus Spend for an Upstream Capital Project Fabrication Work Managing Capital Project Financial Risk through Analytics 2

The effect of cost Effect on Project Economics oil beyond 2005/2006. At overruns on project $90/barrel and a discounted cash financials such as the Unplanned expenses over and flow rate of 8%, the NPV for such a NPV and the IRR are above budget affect both project project would have been over very well known economics and cost controls. As $100B with an IRR of >50%. illustrated in Chart 1, in several Instead, the project has seen instances, cost overruns have economic losses so far because of resulted in the project teams implementation delays (to beyond ignoring cost controls to allow 2015) and cost overruns (to over spend to exceed approved budget $43B). (to avoid work disruption) – in some cases beyond the 10% Capital project development work tolerance limit, before the budget could last for several years and is extended and additional could continue even after first oil. commitment (change order) is During this period, the material formally approved by all relevant and service costs could fluctuate partners. considerably depending upon the demand and supply situations. The effect of cost overruns on The price of oil usually dictates the project financials such as the Net demand condition. When the Present Value (NPV) and the price is high, several new projects Internal Rate of Return (IRR) are become financially viable and very well known. Take the operators start developing them at example of a giant project in the same time, increasing the Kazakhstan2 – the project was demand for engineering, sanctioned at $13B and was procurement and construction estimated to start Front End (EPC) work. Engineering Design (FEED) in 2001. It was expected to pump 1.2mbd (million barrels a day) of Managing Capital Project Financial Risk through Analytics 3

Chart 2: Demand and Supply Forecasts (in Tonnage) for Floaters through 2017 To address the demand, suppliers the analyst to revise both the could augment their facilities and demand and the supply forecasts support systems simultaneously, upwards for all subsequent years. sometimes resulting in the supply overshooting demand. Chart 2 To mitigate the bull-whip effect of shows one such snapshot of the demand and supply, operators do fluctuation in supply and demand execute contracting strategies and for floaters by a reputable analyst hedging options. Good firm from 2011 to 2012. contracting strategies however require engineering and other Here, the demand and supply for functions to provide accurate the floaters were estimated at 1.8M requirements to the procurement and 2M metric tonnes respectively and supply chain function. But if in 2011 for 2012. But the actual these requirements keep tonnage turned out to be 14% and changing, then the effectiveness of 18% higher in 2012. these strategies also drops (considerably in some cases). Also, the forecast estimates were considerably different in 2012 from 2011. In 2011, the industry was expecting the demand to surpass supply. However, despite a robust demand that exceeded the original estimates, the supply continued to top the demand in 2012 leading Managing Capital Project Financial Risk through Analytics 4

A Business For example, a procurement strategies can be modified with Intelligence solution manager could lock in the rental least impact on project financials. is needed by capital rates of an installation vessel for an project teams to extended period of time based on predict future the defined project installation changes with a high schedules in order to obtain cost degree of confidence savings. well in advance so that the existing But if the installation schedules procurement change and they are not strategies can be anticipated in advance due to lack modified with least of visibility and predictive impact on project analytics, then the procurement financials manager may have to change the contract at the last minute. In the process, not only are all the advantages of the prior strategy lost, but also additional expenses may be incurred, especially if penalty clauses are included in the original agreement. For this very reason a Business Intelligence solution is needed by capital project teams to predict future changes with a high degree of confidence well in advance so that the existing procurement Managing Capital Project Financial Risk through Analytics 5

As the project Cost Control effective in the earlier phases of progresses, the project execution. As the project timeframe between While Engineering does play a progresses, the timeframe the work commitment pivotal role in the success of between the work commitment and the work capital projects, several projects and the work execution starts to execution starts to have continued to struggle due to shrink fast, reducing the time shrink fast, reducing poor project cost management. available to the project team to the time available to Most capital projects today use address unplanned project costs. the project team to project cost management systems The project team could have 8 to address unplanned to capture the time phased actual 10 times more time to take project costs costs against the budgeted or corrective actions during the FEED forecasted costs to accurately phase of the project when project estimate the Earned Value (EV) - a activities are Front End Loaded Key Performance Indicator (KPI) (FEL) when compared to the that is used to evaluate the Cost execution phase when the work Variance (CV) or the Cost has either already started or is Performance Index (CPI). The close to completion by the results of such analysis are then contractor. This is illustrated in used to facilitate corrective actions Chart 3 below for the same and to control future project costs. upstream fabrication work mentioned earlier. Project monitoring and control activities however are most Chart 3: Phase Shift between Commitment & Spend for the Upstream Fabrication Work Managing Capital Project Financial Risk through Analytics 6

Cost Assurance To be more effective in controlling its impact on other construction project costs, and to provide and installation activities could project cost assurance rather than provide the necessary assurance cost control, a more proactive against unanticipated cost approach is needed where the increases that affect the project project costs are predicted in economics. Such an analysis could advance rather than the project also tie into continuous team relying upon the present improvement efforts of the project project performance. teams around standardization and simplification. One approach to predicting this future cost is to analyze leading In order to conduct any analysis indicators such as commitment effectively however, the requests from the contractor information related to the analysis (variation order requests or VORs) needs to be available centrally. and work requests from the Today, capital project teams are operator that are likely to translate having to focus on where to get the into future commitments. information for the analysis instead Understanding the implication of of conducting the analysis itself. such requests beyond the Even if they know where the requested work itself can provide information resides, they have valuable insights into the Total challenges getting access to the Cost of Ownership (TCO) of the various project information change. For example, if the management systems including contractor were to request for a finance, project planning and platform deck crane capacity procurement. increase, then this specification change may require a pressure Projects utilize different increase of hydraulic utility, specialized systems, both internal material change of certain and external to the operator components (like changing the organization to record different grade of steel used in the crane activity sets. In most cases, the and other parts), additional records are not normalized across platform space, additional systems. While integrating these transportation and installation systems could resolve some of the costs and so on. normalization and data quality issues, such efforts are not always A detailed value engineering or economically and/or technically value analysis on such requests feasible. with a thorough understanding of 7

Global Projects Analytics Solution A preferred approach to developing project analytics capability is to build a separate Projects Business Intelligence Solution (PBIS) that consists of a data warehouse and a data visualization tool. Chart 4 shows a PBIS architecture. Chart 4: Project Business Intelligence Solution Architecture Legend Active Data Source Project Business Intelligence Solution (PBIS) Potential Data Source Data Sourced Data Visualization Project Control & Project Quality Data Project Risk Management Management Warehouse Information Management System System System System Project Name, WBS, Activity Budget Change Actual Forecasted Supplier, FM, AFE, Schedule Allocation Requests Commitment & Commitment Contract Account Commitment Information Codes Project Plan & Cost Supplier Change, Spend & Spend Schedule Management Communicati Sourcing Financial Procure to Contract System System Management System on System Pay (P2P) Planning System System System A typical Offshore/Deepwater capital project has a themselves could be as high as 50% of the spend spend of more than 5 Billion dollars. Of this spend, ($1.5B). fabrication/construction, transportation and installation activities (about 60% of the spend - $3B) An operator could conservatively save more than 1% account for most of the changes that occur and require ($15M) of this $1.5B in change by identifying and a robust cost assurance capability. The changes resolving them earlier with the help of a PBIS. Managing Capital Project Financial Risk through Analytics 8

Data Visualization The data visualization plays a critical role in the efficient use of a PBIS. Chart 5 shows a data visualization dashboard developed in Spotfire, exhibiting project information across multiple dimensions. Chart 5: Capital Project Data Visualization Dashboard Through such dashboards, spend, schedule and their filtered and studied further. If required, the project leading indicators could be analyzed at the nodal level team could drill down to individual transactions within of individual dimensions, aggregated to higher levels such categories to better understand the reasons and compared against each other. For example, the behind the deviations and to institute the necessary analysis could involve comparing and contrasting corrective actions. similar project activities or categories of work, reviewing contractor performance across different Patterns could be recognized and extrapolated using projects and evaluating exceptions (such as sudden time series models to provide future forecasts. spikes in spend and so on). Spend could be Statistical models developed through such techniques categorized and categories subject to frequent could then be continuously improved to get better fit deviations from planned/forecasted values could be between the forecasted and the actual values. Managing Capital Project Financial Risk through Analytics 9

Conclusion In conclusion, there is a big opportunity to improve capital project cost management by deploying a Projects Business Intelligence Solution (PBIS) to analyze the project spend, schedule, and their leading indicators. A well designed PBIS with a versatile data visualization layer and an effective data capture mechanism should be able to generate actionable insights for the project team to go beyond controlling project costs to providing project cost assurance. Acknowledgment I would like to thank Bill Loper, Edgar Dias and Valerie Berhendt for reviewing this white paper and providing valuable inputs. The data accuracy issue may References be best addressed by sourcing each parameter in the data 1. Spotlight on oil and gas store from a project system megaprojects, EY that serves as a system of record for that parameter. For 2. Oil firms in Kazakhstan, example, the cost forecast Economist; How a Giant Kazakh Oil information would come from Project Went Awry, WSJ the cost management system while the actual commitment 3. Why projects overrun, and what and spend data would be to do about it, Westney Consulting received from the Enterprise Group Resource Planning (ERP) System where all financial 4. ExCap II: Top-Level Thinking on reconciliations take place. Capital Projects, ATKearney About the Author Swami Ranganathan is an Oil & Gas professional based out of Houston, TX. For any queries regarding this paper, he can be best reached at [email protected] or +1-214-578-0845 10