Rising capital costs provide warning to Arabian Gulf petchems developers

Construction costs for petrochemical and refining projects in the Gulf Cooperation Council (GCC) region are up 2-4 times compared to 14 years ago, according to Koen Vermeltfoort, principal Capital Productivity Practice at McKinsey & Company.

Speaking at a Petrochemical Update webinar on April 6, Vermeltfoort discussed the major risks to delivering projects on time and on budget and the new strategies to improve planning and execution amid low oil and capital budget crunch together with Ali Vezvaei, president and CEO EMEA at Linde MENA.

General industry inflation accounts for one third of the project cost escalation, while two-thirds is due to either specific factors such as local content requirements or to issues within the owner companies’ control, such as larger scope definitions and tighter equipment specifications, Vermeltfoort said.

Meanwhile, the oil and gas industry in the GCC has fallen behind other capital-intensive sectors, such as aviation and automotive, in adopting best practices and improvements in project execution in the last 15-20 years, he added.

While about 70-80% of production expenditures in the process industry depend on feedstock and energy costs, companies that are adding new capacity can save millions of dollars in capital expenditure by ensuring that their projects are completed on schedule and within budget.

There are currently a total of $32.5 billion active refining projects under construction in the Middle East on the back of rapid demand for motor & jet fuel and petrochemical feedstock, according to Industrial Info Resources (IIR).

Refining capital projects at the planning & engineering stage that are announced to begin construction in 2016-2018 total about $53 billion (280 projects). Chemicals projects proposed to kick off construction in 2016-2017 total about $56 billion, though difficulties in securing investors has stalled new ethylene capacity additions in 2016, according to the IIR.


Many downstream companies in the GCC region have slashed capital budgets as the oil price drop has cut cash flows.

Major risks

Contrary to popular opinion linking project cost escalation to growing supplier margins, the revenues of most suppliers in the region have grown by roughly the same percentage as capital investment while their EBITDA percentages (Earnings Before Interest, Taxes, Depreciation and Amortization) have stayed fairly flat, according to McKinsey research.

Vermeltfoort said that higher project costs are mostly due to three major factors: changes in scope, including labor wage growth and increases in the specifications for certain goods and materials; falling productivity in the energy sector even as most other industries are getting more productive; and the environment.

Construction productivity has also suffered as more and more companies are starting to outsource work to low-cost engineering and construction centers abroad, which hampers EPC companies’ ability to maintain the same quality of engineering standards and supervision.

“A significant amount of improvement is needed in managing this multi-location,” Linde’s Vezvaei said.

Meanwhile, three quarters of project slippage are due to missing out on project basics, such as clarity of schedule, managing the project interfaces and establishing trust between the project partners, according to Vermeltfoort.

Moreover, according to Vezvaei, the GCC downstream construction industry has become “overly complex” as it has rushed to adopt multiple norms and standards that have not visibly improved project performance compared to previous years.

Modular construction

The GCC petrochemical producers could achieve an additional 10% in return on investment through optimizing every aspect of their operations, including during project planning, engineering and construction, according to a report by the Gulf Petrochemicals and Chemicals Association and McKinsey published in November 2015.

Companies in the region could achieve a 2-3% return on invested capital (ROIC) in capital projects, for example, through optimizing project design, increasing the level of standardization and applying lean construction approaches.

According to Vezvaei, the downstream industry has also lost touch with innovation and can dramatically improve its project performance if it adopts intelligent devices and models such as “plug and play” construction, which are already trialed by major producers like Shell.

The heated construction market has also prompted more and more owners to pilot modular construction for mega projects to mitigate some of the local risks. A growing number of the region’s producers are beginning to ask their EPCs to complete their project design using a ‘modular constructability’ approach, while more and more contractors are trying to start partnerships with fabrication yards around the world to take advantage of economies of scale, Vezvaei said.

At the same time, global sourcing means petrochemical and refinery owners should routinely assess the engineering and fabrication shops’ productivity, rework rates, weld rejection rates and other metrics for quality assurance early in the project cycle.

Companies that use global engineering centers should also adjust their staffing strategies to ensure good communication between the different project interfaces and locations, the panelists said.

Contracting strategies

Most developers and foreign investors in the GCC still prefer to lock in less risky lump-sum, turnkey (LSTK) pricing so that they can get access to financing. Another reason for the higher reliance on LSTK contracts in the Middle East is that most owner companies in the region don’t have big in-house engineering capabilities and prefer delegating this to a qualified contractor.

Cost-reimbursable contracts, on the other hand, require a lot more control of inflation, intervention, management and support from the owner side.

However, more owners in the Middle East have significantly improved their contracts since 2007-2008 and are starting to consider other, more sophisticated contracting approaches – that include incentive schemes – to get better control of project timelines, budgets and communications in the changing market and project construction environment.

Companies in the region are, for example, becoming more open to deals that allocate the risk to where it can be handled best rather than simply sharing it equally between the owner and the contractor. This strategy is different from risk shifting, which often turns into “risk dumping” in a more heated construction market, Vezvaei said.

“They realized that by shifting, parking or even pushing the risk to the contractor, it does not necessarily make the overall project less risky. It just parks the risk where no one can then fix it afterwards,” he added.

Though promising, the shift has been slow to grow in the region as most of the larger state-owned projects and companies are legally bound by governmental requirements and as the industry has had to adjust to the influx of foreign general contractors, particularly from Asia.