07-02-09 buildingLNGNEWFACILITIES

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What is the outlook for building new LNG facilities?

Rising construction costs will play a large part in determining what plants are built

T. Phalen and J. Scotti, Fluor Corp, Houston, Texas

[email protected]

Global natural gas (NG) demand is forecasted to rise at an average rate of over 2%/yr. On aworldwide basis, available NG supplies exceed demand. However, there is a mismatch between gasproducing regions and gas consuming regions. Liquefied natural gas (LNG) production andtransportation is one answer to solving this mismatch. For this reason, most forecasts, including theInternational Energy Agency (IEA) WEO 2006 forecast, predict that up to 70% of the increase in gastrades among regions will be LNG. Overall, between 2004 and 2030, IEA expects LNG demand togrow by 6.6%/yr, a similar rate to the preceding decade.

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Need for new LNG supplies. Several LNG liquefaction trains are in construction and are scheduledto come online over the next few years to meet current demand. Forecasters are predicting that evenwith liquefaction capacity currently under construction, LNG supplies will fall short of demand by the

year 2015.2 Frank Harris, head of global LNG for Wood Mackenzie predicts that this crossoverbetween supply and demand will occur in the 20132014 time frame.

3The time to construct an LNG

project in today's environment is four years. To meet future demand requirements, the next wave ofLNG projects are being studied. In fact, Woodside Energy has announced plans to construct a newLNG train every two years and, in total, 17 new LNG projects have been announced in the Australia,Timor Sea and Papua New Guinea region.

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However, rising facility costs coupled with uncertainty in the delivery of projects have caused ownersto evaluate the attractiveness of proposed projects. The volatility and risk introduced into the globaleconomic outlook over the last few months just serves to amplify the uncertainty surrounding projecteconomics.

Based on the list of currently announced projects, the most likely region to produce the next round ofLNG facility construction is also the one with the most intense competition for resourcesWesternAustralia. Prevailing wisdom is that not enough engineering, procurement and construction (EPC)capacity is available to meet the needs for potential projects in this region.

Fig. 1 Contractor backlog trends. EPC contractorbacklog has doubled in three years.


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Fig. 2 Process plant industry bookings for contractors;manpower requirements grew by over 90%between the start of 2004 and the end of 2007.

Why is the market reluctant to proceed with all of these projects in parallel? In a word: Risk.LNG liquefaction projects are large, complex programs located in remote areas requiring significant

new infrastructure. The large capacities associated with each proposed project, coupled with futuremarket uncertainties and lengthy times-to-market for newly authorized projects (typically five yearsfrom authorization to commercial operation) expose these projects to increased risk relative tocompeting projects. The size and breadth of each project can put a tremendous strain on regionalresources.

Unprecedented price escalation further complicates project financial viability. From 2005 through2008, all indications are that LNG project costs have escalated in excess of the 20%/yr rate ascompared to other upstream projects, thus creating a high degree of economic uncertainty forliquefaction projects.

LNG liquefaction costs were reported around $200/metric tpy (mtpy) in 2005.5

However, 2005 may

represent the low point for LNG facility construction costs. Currently, onshore LNG liquefaction costsare being reported in the range of $1,300/mtpy to $1,500/mtpy of capacityan average annualincrease of 50% to 60% in the price per ton.

6These reported increases are on the high side of actual

experience, and the mtpy for a well run project is probably the minimum expected cost in the currentmarket, implying the average annual increase in the cost of facilities is still 30% to 45%.

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What factors are driving sharp price increases for LNG facilities? Demand for EPC services,equipment and material has experienced record growth, with all sectors of the market rapidlyexpanding infrastructure after years of neglect. This growth has strained existing resources in severalareas. Market conditions impacting LNG facility projects include:

Doubling of the EPC project technical resource requirements between 2005 and 2007, withCambridge Energy Research Associates (CERA) reporting a possible 10%15% deficit of

people to staff projects by 2010.8 Average current shop loads at 70%100% of available capacity, as opposed to 60% average

load over the previous 10 years. Escalation in two key commodities for LNG facility constructionstainless steel pipe, and

large compressors and gas turbineswith total increases of 90%150% and 20%50%,respectively, during 20062007. Escalation for 2008 slowed to 10%20% for stainless steelpipe and 5%15% for compressors and turbines;

9however, costs for carbon steel/pipe

increased by 70%90% in the first half of 2008. Constraints on the availability of skilled and unskilled labor to support construction, with a

potential shortfall of 15% in skilled labor in 2008.

Each of these factors contributes to the total cost escalation as the industry resorts to the age old

method of allocating scarce resourcesprice increases. In addition, the shortages and constraintstend to lengthen the development and construction cycle of facilities, further straining overall projecteconomics and resources.


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The convergence of each of these factors at the same time frame is driving the size and breadth of theincreases. In addition, the facility increases are also being driven by increases in the overall pricingand schedule uncertainty within the EPC market.

Contractors are pricing in increased contingencies across all EPC markets to factor in theuncertainties around obtaining the required resources and materials in a timely fashion and at the

price predicted. This is particularly true in the LNG facility market as these projects tend to be inremote locations with limited infrastructure. They also are complex projects with multiple partners andlarge capital facilities.

Contractor capacity limitations. The global energy sector is facing a severe shortage of qualifiedtechnical resources. Since the early 1980s, the investment in energy and infrastructure has beenrelatively low. The industry as a whole has focused on internal efficiencies and cost cutting as amethod for enhancing profitability. As a consequence, the number of technical workers activelyemployed in the industry has declined dramatically.

Recent concurrent growth in capital investment in all sectors of the energy and infrastructure marketshas strained the available technical resource pool to the breaking point. The need for technicalresources in all parts of the energy sector and, in particular, for EPC contractor services hasskyrocketed. According to a new analysis by CERA, there could be a potential 10%15% deficit ofpeople by 2010 to staff the over 400 major projects expected to come onstream over the next fiveyears.

8A major EPC company's internal review of the publicly reported backlog for 12 major

contractors in the engineering and construction industry shows that contractor backlog has doubledover the last three years. While this trend is expected to moderate over the near term, the contractorcommunity continues to experience unprecedented workloads. Limited excess capacity is available inthe system to absorb new work.

This growth in backlog is reflected in the demand for technical resources. An internal EPC company'sforecast of industry manpower requirements for the same period indicates that manpowerrequirements to meet these growth demands almost doubled between the beginning of 2005 and theend of 2007. This growth is forecast to level out for the near term. However, resources will continue to

be strained. This forecast is based on available data on capital expenditures and trends in the industryand assumes continued strength in global oil prices.

This accelerated growth in an industry facing an aging work force and years of declining population isputting a severe strain on the resource pool. Contractors have responded to this demand for resourceby increasing pricing for services and stretching project time lines in an attempt to level demand andmeet the available needs. The results are higher costs for engineering and management services andlonger project time lines.

In the LNG marketplace, this effect has been magnified. LNG liquefaction has been dominated in thepast by a few contractors. In recent years, the number of contractors involved in the engineering,procurement and construction of LNG projects has increased to include other major contractors. Yet,the experienced resource pool remains limited. Since 1994, the backlog of LNG train construction has

more than doubled. In addition, LNG projects continue to compete with other energy projects forresources as these same technical personnel can work on refineries, gas plants or chemical projects.

As the demand for large, complex LNG projects grows, the expansion in price and scheduleaccelerates to moderate demand. Given the current market conditions, cost increases of servicestranslate directly into a corresponding increase in the total LNG facility capital cost. Scarcity of keyresources translates into extended EPC schedules.

To combat this problem, owners should engage and commit contractor resources early in the projectdevelopment cycle. The old strategy of competitive bids at each stage of a project in today'senvironment can result in qualified bidders declining to participate, risk premiums being added topricing, and uncertain access to qualified project teams. By committing early in the project

development to an EPC contractor and working with them to develop a viable strategy, an LNG facilityowner can tie up valuable resources for the project and lower risk. The schedule and risk benefits of


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this approach can typically outweigh any cost advantage relative to a traditional competitive bidapproach.

In addition, an LNG facility owner can broaden access to key resources by using teams of contractorson its projects. The liquefaction portion of any LNG facility project typically represents 34%38% of thetotal projecta large undertaking by itself. By employing several contractors on the nonliquefaction

work, an owner can reduce risks by increasing the pool of qualified resources to complete the work.Also, the owner can take advantage of the relative strengths for each contractor.

Escalation of equipment and material. The rising demand for equipment and materials to supportprojects across energy and infrastructure projects has strained suppliers' ability to respond, resulting indelivery schedule and cost increases. Logistics challenges have compounded these challenges. Anincrease in demand for shipping resources to move materials and equipment from one continent toanother, combined with growing worldwide consumer demand, has resulted in longer transit times andgreater need for advance planning. The net result is that, even when materials and equipment can besourced from lower-cost regions, higher transportation prices and increased lead times may stillnegatively impact project financials, leading to cancellations. Even among finished goods supplierswho are not experiencing labor or production capacity issues for their products, competition exists forraw materials with other equipment manufacturers. The current constraints span the raw materials,

finished materials and equipment sectors.

All of this demand for equipment and material has resulted in continued price increases, extendeddelivery times and increased shop loads as illustrated in Fig. 3. In 2006 alone, stainless steel pipe, akey commodity for LNG facility construction, experienced a 45%60% price increase. This wasfollowed by an increase of 25%40% in 2007. Major compressors and gas turbines also experienced asignificant increase in costs. In the same years, 2006 and 2007, the cost of these machines jumped15%25% and 8%20%, respectively. Other commodities also showed sharp increases in the sameperiod.

Fig. 3 Equipment and Material Escalation Forecastcompressors and stainless steel.


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Fig. 4 Intense demand for construction resources globally.

The impact of material price escalations on LNG facility costs was dramatic. Projects seekingauthorizations during this period faced an uncertain future in terms of price and delivery of keymaterials. In this environment, it was difficult to predict the ultimate economics for a project, ultimatelyresulting in several project delays or cancellations.

Going forward, some moderation of equipment and material escalation is expected. In 2008, the cost

escalation followed the trend of the previous two years. However, there are signs that these increasesare moderating. Over the near term, steel prices may see a decline. The steel market will likely offermore favorable pricing mid- to late-2009 through 2010. Certain finished product equipment supplierswill continue near capacity until current orders are filled, followed by a period of available capacity inmid-2009. Based on current backlog of orders, suppliers will hold on to current margins as long asthey can. However, mid- to late-2009 may be a good time to be a "buyer" again. This could be goodnews for LNG projects going forward. Equipment and material pricing should stabilize and provide a"window of opportunity" for projects to move forward with a level of certainty.

Early procurement strategy. To capture this window of opportunity, owners may want to apply anearly procurement strategy. Early procurement will allow owners to lock in pricing at favorable levelsand to limit the project's exposure to future inflation. In addition, early procurement has provensuccessful in addressing market constraints to keep projects on schedule and within budget. By

identifying long-lead materials and equipment during the facility design phase, purchasing becomes astrategic function that supports execution in line with the project's desired parameters.

This approach requires close integration of the EPC contractor and supplier, who work in conjunctionwith the owner to prioritize decisions related to supply constrained items. In essence, suppliersbecome partners in the design process. An added benefit is that an integrated approach reduces oreliminates duplication in the supply chain. This reduces the demand for critical engineering and skilledlabor resources. This strategy has been validated by Construction Industry Institute research and iscritical in today's overheated environment. Partnering with key suppliers during the developmentphase of a project can inject more predictability into the equipment and supply chain. The net result isa more controlled, managed and efficient project cost and schedule.

Scarcity of construction labor. Rising demand for construction labor supporting projects across aspectrum of EPC projects has highlighted a declining pool of skilled labor. Several international "hotspots" have emerged as areas of high construction activity. They include Alberta, Canada; Western


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Australia; West Africa and the Middle East. Out of these four areas, Western Australia (WA) is also anarea of high actual and potential LNG construction activity. Mark Greenwood, JP Morgan energyanalyst, notes that the labor shortage "is going to prevent projects from proceeding. There are eightmajor new LNG projects planned in WA and the Northern Territory targeting startup between 2012 and2015, and we expect only two or three of them will get up and running. The rest of them will bedelayed and labor will be a constraining factor."

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The short supply of skilled workers is driving wages and project costs higher. During the past fouryears, Australian local construction labor costs have jumped 38%. "Gaining access to experiencedpeople is becoming a long lead item for projects, with the boom in resources and generally tight laborsituation in Australia. This is not expected to change in the near term," said Jim Willetts, WoodsideEnergy.

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In the past, the "457 Visa" that enables Australian businesses to sponsor skilled overseas workers tofill positions on a temporary basis has not been applied widely in the Australian construction industry.Today, large resource projects are pursuing reforms to the sponsorship, monitoring and complianceobligations associated with this labor source. Pay and conditions for these skilled overseas workersare aligned with project wide union agreements and, consequently, the cost of the skilled overseasworkers typically exceeds that of similar local workers.

One approach to improving labor productivity and overcoming shortages is the increased use oftechnology. However, applying technology in construction work places additional demands on skilllevels needed among both field craft and staff. Projects demand higher technical competence, arealso creating a demand for improved training and education. The limited quantity of technically literateconstruction resources is also expected to exacerbate the labor shortage's inflationary impact.

Modularization. Prefabrication has been used in the past to cope with labor shortages. Streamliningthe construction process at the job site allows for the quality- and logistics-controlled production oflabor-intensive portions of work in controlled environment. This allows skilled labor to work in acentralized location with greater total efficiency, as the resources are not dedicated to a single projectbut may alternate between projects with no time lost traveling from one dedicated site to another. This

also results in lower costs, both in wages and travel, as well as opening of the market to specificskilled labor that would resist relocation. The declining fuel costs will also help the economics ofmodularization as transportation expenses will also decline.

Modularization use in nontraditional areas such as LNG and mining construction projects, as well asthe increasing demand from traditional projects, is placing a strain on fabrication yard capacity.

McDermott's Indonesian yard completed the fabrication of modules for the fifth LNG liquefaction trainfor the Woodside operated North West Shelf facility in Karratha, Australia. Modules for Woodside'sfirst Pluto LNG project, also in Karratha, are currently under fabrication in Thailand. Moving modulefabrication offshore has become a cost-effective solution to resolve the skilled labor shortage inAustralia. The success of a modular approach also requires an efficient engineered solution to moduledesign, good craft productivity in the fabrication yards and proper management of shipping.

However, the large LNG projects currently proposed may require on the order of 100,000 tons ofmodule fabrication to reach their goals of reducing site labor. This potential fabrication volume will puta strain on worldwide fabrication capacity. Yards capable of fabricating the complex modules expectedfor an LNG project are currently running at near capacity, providing little relief to the labor shortages'inflationary pressures. As illustrated in Fig. 5, worldwide demand for module fabrication is predicted tosurpass supply in the same period as the predicted LNG construction. LNG module fabrication willhave to compete for this scarce fabrication capacity with other energy projects making project planningand logistics difficult. The key to success will be early planning and commitment of fabricationcontractors.


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Fig. 5 Global demand for modular fabricationglobaldemand exceeds supply.

Despite the potential difficulties, this approach has been applied to upstream projects for years. Withthe proper planning and experience, it will continue to be the best option for managing LNG facilityrisks going forward. At present, limited LNG facility modularization has taken place. We would expectthis to increase and become more sophisticated with the next round of facility construction.

Outlook. In the short term, we can expect LNG facility cost escalation to continue at a similar high rate

for the next few years. There are signs that the equipment and material pricing is beginning tostabilize. If this occurs in 2009, then we can expect more stabilized cost growth going forward.However, this stabilized escalation trend is still expected to be higher than historic norms.

To combat and manage the cost uncertainties facing the LNG EPC market and to lower project risks,these strategies can be applied:

Commit EPC resources early in the project. Owner's should partner with an EPC contractor earlyin the project development cycle and get key project management, engineering and constructionresources committed to the project. Early construction planning can mitigate labor shortage issues.

Utilize multiple contractors for a project. Owner's can broaden their access to key resources by

engaging multiple contractors in a single, large, complex project.

Strategic sourcing and supplier integration. The opportunity to influence project cost is greatestat the beginning of a project. By bringing suppliers into the project early, one can improve the securityof supply for critical components, improve overall facility optimization and reduce work requirementsfor critical engineering service firms by eliminating duplication.

Modularize facilities. Modularization is an acknowledged strategy to combat the impact ofconstruction labor shortages. Streamlining the work processes at the site and shifting labor to a morecontrolled yard environment reduces construction cost risks.

Engage module fabricators early. Fabrication capacity will be at a premium in the near term. It is

essential to engage fabricators early in the process to commit available capacity and drive designefficiencies. Designing to known fabricator capabilities will improve project economics and laborutilization.

Modify contracting strategies to improve risk sharing. Contracting strategies, which applyreimbursable terms or negotiated lump sums to share the risk, can reduce risk premiums andcontingencies to lower overall project costs.

The increasing demand for LNG over the next 20 years means there will be a corresponding demandfor LNG facility construction over the same period. The question is: Who will construct the facilities tomeet this demand? Rising costs in LNG construction will play a large part in determining what plantsget built. The use of key strategies to mitigate cost increases and reduce risk will improve the profile ofany potential project. HP

Acknowledgments


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The authors would like to thank Fluor Corp. management for permission to publish this article. Ourgratitude also goes to colleagues at Fluor Corp.Daryl Johnson, Harry Homan, Patti Nanney andothers, for their contributions and constructive comments while writing this article.

LITERATURE CITED

1 National Petroleum Council, "Facing the Hard Truths about Energy," July 2007.2 "Despite rising costs, global LNG supply is set to increase dramatically over the next eight years," IndustrialInfo.com, Dec. 11, 2007.3 "LNG likely to be in short supply by 2013, says forecast," Hydrocarbon Processing, July 2007, p. 17.4 "Skill woes cloud LNG Plans," News Limited Australia, Sept. 27, 2008.5 Yost, C. C. and R. N. DiNapoli, "LNG Plant CostsPast and Present Trends and a look at the Future," AIChE Spring Meeting, 5thTopical Conference on Natural Gas Utilization, April 1014, 2005.6 "Samsung Heavy Industries secures $567.8 million floating storage and offloading LNG order," Industrial Info Resources, Sept. 26,2008.7 Jenson, J. T., "Special report: Global LNG Trade to 2020 marked by uncertainty," Oil and Gas Journal, Feb. 25, 2008.8 "Engineering Talent Squeeze'People Deficit' Like to Cause Further Delay in Some Oil & Gas Production Projects through 2010:CERA," news release, Cambridge Energy Research Associates, Oct. 4, 2007.9 "2008 Material Market Outlook," Fluor Supply Chain Solutions, January 2008.

Bibliography

"Upstream project costs showing signs of peaking, says CERA," Hydrocarbon Processing, July 2007, Vol. 86, p. 17.Phalen, T. and J. Scotti, "Update on LNG facility construction," 2008 OTC conference proceedings, OTC 19306, May 2008.

The authors

Tom Phalen is vice president of upstream operations at Fluor Corp. He has over 32years of experience in the engineering and construction industry. His career with Fluorhas included assignments in process engineering, pipeline engineering, engineeringmanagement and project management and as general manager of the Houston office.He is currently responsible for directing Fluor's upstream project operations for NorthAmerica and LNG facilities on a global basis.

Jim Scotti is senior vice president and chief procurement officer at Fluor Corp. He isresponsible for $11 billion annual spending and more than 2,000 resources inprocurement, contract management, material management, sourcing, travel services,logistics and export control within Fluor worldwide. Fluor procurement is a center-ledapproach that emphasizes global sourcing and leverages the company and projectspend across all business groups.

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