Risk on complex projects

Abstract

Imagine you are the program risk engineer for a new refinery being built in the Middle East. The front-end engineering and design (FEED) phase has been completed, and the project will be entering a key phase: procurement. Key decisions need to be made regarding the procurement strategy, the timing of the tendering process, and the number of packages on which contractors will bid. What advice would you give the program director? This case study walks participants through the story, pausing at crucial decision points to ask participants how they would respond to the situation.

Decision-oriented case studies are structured and written from the viewpoint of a key player, the protagonist. They are framed around information available to the protagonist at the time of the event. The case typically builds to a point where the decision-maker is confronted with open-ended choices. The audience is left to analyze the information and scenarios and then make critical decisions based on contextual analysis. This paper follows the NASA/GSFC case study development methodology for case studies. (National Aeronautic and Space Administration [NASA], 2008)

Introduction

A case study may be understood best as a narrative, based on actual events, that creates an opportunity for conversation, problem analysis, and virtual decision-making. An effective case study transfers specific knowledge by placing the student or workshop participant in a position to think through choices faced by decision-makers in real-life situations. By confronting actual scenarios, participants develop and refine analytical skills for solving similar problems in their own projects (NASA, 2008).

The Practice Standard for Project Risk Management published by the Project Management Institute (PMI, 2008b) describes standards for risk management that are recognized as good practice on most projects most of the time. Do complex projects require any different or additional processes or procedures than the standard describes?

In A Guide to the Project Management Body of Knowledge – Fourth Edition (PMBOK^® Guide), “project risk is an uncertain event or condition that, if it occurs, has a positive or negative effect on at least one project objective.” (PMI, 2008a, p. 275) The definition for Project Risk Management, as defined in the PMBOK^® Guide, is “Project Risk Management includes the processes concerned with conducting risk management planning, identification, analysis, responses, and monitoring and control on a project.” (p. 273) PMBOK^® Guide also states: “The objectives of Project Risk Management are to increase the probability and impact of positive events, and decrease the probability and impact of negative events in the project.” (p. 273)

Practice Standard for Project Risk Management identifies three critical success factors for risk management: (PMI, 2008b, p. 21-22)

• Identify and Address Barriers to Successful Project Risk Management
• Involve Stakeholders, and
• Comply with the Organization's Objectives, Policies, and Practices.

Oil and gas joint ventures (JV) sometimes do not have fully developed policies and procedures in their early stages. If risk management procedures are not part of the procedures the JV has compiled, effective and practical risk management procedures need to be put in place.

The standard also identifies ten critical success factors for identifying risks: (PMI, 2008b, p. 25-27)

• Early Identification
• Iterative Identification
• Emergent Identification
• Comprehensive Risk Identification
• Explicit Identification of Opportunities
• Inclusion of multiple perspectives
• Fully described risk statements
• Risks should be related to at least one project objective
• Assignment of an owner to a single risk, and
• Maintaining an objective view and exposing bias.

Using multiple risk identification techniques is recommended (PMI, 2008b). A project may choose to use a risk universe checklist (historical review), together with assumptions analysis (current assessment) and brainstorming (creativity).

The Context – Risk in Oil & Gas / Complex Programs

The design and construction of a refinery is inherently complex. The FEED (front end engineering and design) is the most critical stage where it's easy to influence the design at a relatively low cost (Whiteside, 2010). However, risk can occur at any project stage. One refinery in India, for example, experienced financing problems, design issues, was partially destroyed during construction, and was underinsured. Eventually it was completed in 13 years. The original schedule was 4 years (Hydrocarbons, 2009).

This case study views risk from the owner's rather than the contractor's perspective.

Oil Refinery Program Background

Developed by Wilbur L. Nelson in 1960, the Nelson complexity index (NCI) describes a measure of the secondary conversion capacity of a petroleum refinery relative to the primary distillation capacity (Nelson Complexity Index, 2012, ¶1).

The index indicates the investment intensity of the refinery and its potential value addition; the higher the number, the greater the cost of the refinery and the higher the value of its products.

The refinery in this case study has a Nelson complexity Index of 10.6. As a comparison, the average NCI of the United States refining industry is 10.9 (Satorp, 2011). Europe refineries have an average rating of 6.5. (Nelson Complexity Index, 2012, ¶4). So while the Refinery can be considered complex, it is comparable with the average US refinery.

The refinery will process low cost Arabian heavy crude oil to produce high value refined products, Liquified Petroleum Gas (LPG), petroleum coke, liquid sulfur and petrochemical products (paraxylene, benzene and propylene) that meet the global market's most stringent product specification s. It will benefit from close proximity to the Arabian heavy crude supply system in the Arabian Gulf and from the facilities of the Jubail Industrial City, including water, power, other utilities, infrastructure and a residential section. It will also benefit from the facilities at the King Fahad Industrial Port.

“The Refinery will be located on a 480 hectare site in the industrial area of Al-Jubail known as Jubail 2 in the Kingdom of Saudi Arabia (KSA). This is a newly developed area of Jubail that will be equal in size to the presently developed industrial city (now termed Jubail 1). Jubail 2 lies inland from Jubail 1 on the opposite side of the main E-W highway and pipeline. The Project will be the major new project on the Jubail 2 site, and is the first expansion of the industrial city since it was originally laid out in the early 1980s..

In addition to the site in Jubail 2, SATORP has been allocated 17 hectare of land in the King Fahd Industrial Port for storage as well as access to 5 berths at the port for the shipment of its products, including petroleum coke. (Satorp, 2011, p.392)

Project Objective

“The competitive advantages of the Project from a technical perspective are:

• Large-scale capacity (400,000 barrel per day capacity)
• Access to low cost utilities and infrastructure in the Jubail Industrial City
• Strategic location with reach to the European and other markets
• Full conversion of fuel oil into high value distillates with rejection of carbon as coke)
• Use of lower-cost heavy crude feedstock (Arabian Heavy crude)
• High value petrochemical production (equivalent to 5 wt% of crude oil feedstock)
• Competitive modern process technology, with proven plant design, supplied by the leading licensors
• Secure long-term supply of a single crude oil from Saudi Aramco” (p.395).

“Process technology has been licensed from reputable licensors and all technology is commercially proven in operation of a similar scale and duty in other operating plants. The key licensors are:

• Axens—NHT/CCR (Naphtha Hydrotreater/ Continuous Catalytic Regeneration), Aromatics, FCC (fluid catalytic cracking)
• Chevron-Lummus Global—Hydrocrackers
• DuPont —Sulphuric Acid Alkylation
• Foster Wheeler—Delayed Coker
• UOP—Middle Distillate Hydrotreaters” (p. 392)

Joint Venture Partners

The refinery is owned 62.5% by Saudi Arabian Oil Company (Saudi Aramco) and 37.5% by TOTAL Refining Saudi Arabia SAS Limited (TOTAL) registered in France, a wholly owned subsidiary of TOTAL S.A.

Key Stakeholders

The Saudi Royal family is a key stakeholder as the refinery is to be constructed on land leased under a 30 year operating lease agreement with the Royal Commission. The lease is renewable by the Company for similar periods under mutually agreed terms and conditions for the benefit of the Company.

Other stakeholders include the executives of the two joint venture partners and team members including internal contractor staff. Commercial tenants in the Jubail Industrial City will be stakeholders as well.

Cost and Financing

The refinery is estimated to cost about $12 billion. Refinery Management plans to use commitments from Export Credit Agencies and certain international and commercial banks to provide the company with senior secured term loan facilities at favorable pricing and loan guarantees. These include the Public Investment Fund of Saudi Arabia and the Export Credit Agencies:

• SACE - S.p.A. Servizi Assicurativi del Commercio Estero - Italy
• JBIC - Japan Bank for International Cooperation
• NEXI - Nippon Export and Investment Insurance - Japan
• KEXIM - Export-Import Bank of Korea
• KEIC - Korea Export Insurance Corporation

The refinery will be funded in the early stages through shareholder loans. Expenses to date are about US$100 million, which include FEED costs.

Market and economic context

Oil demand has been relatively soft since the global economy went into recession in 2009. The Project refinery is an export oriented facility, processing Arab Heavy crude oil to produce gasoline and diesel.

“There is ample feedstock available for the Project from Saudi Aramco, one of the two joint venture partners. The future sustainable capacity for Arab Heavy production is estimated to be at least 2.4 million barrels per day (b/d), whereas domestic demand (including the Project) is not expected to exceed 1.3 million b/d” (Satorp, 2011, p. 422).

Wood MacKenzie performed an analysis of the Project using a Net Cash Margin (NCM) approach and found it placed very competitively when compared with other refineries. NCM captures most of the critical elements of a refinery's performance that define its competitive position in the short / medium term; NCM is defined as:

“NCM ($/bbl) = Product Worth ($/bbl) - Cost of Crude ($/bbl) - Cash Operating Expenses ($/bbl)

NCM multiplied by annual crude refinery throughput is effectively equivalent to EBITDA (Earnings before Income Taxes, Depreciation and Amortization). EBITDA is a metric used by loan covenants and investors.” (p.410)

Exhibit 1 Future Competitive Position of the Project vs other Global Conventional Fuels Refineries (Satorp 2011, p. 411)

Your role

You are a contractor who has been brought into the project as the Program Risk Engineer. The Joint Venture does not have specific Risk Management procedures in place, but wants to follow good practices for project risk management.

Project Timeline Overview

Exhibit 2 - Project Timeline Overview (Satorp 2011, p. 391)

Key Milestones

June, Year 1, Award of contracts

January, Year 2, Start Construction

March 1, Year 3 15% Equipment on site

July, Year 3 60% equipment and 30% piping | Spools

October 1, Year 3 1st commissioning

December, Year 3 90% equipment 50% piping Spools

May 31, Year 4 Final Commissioning

October 31, Year 4, Final Startup

Current Phase – Procurement and Tender Timing

The project has completed the FEED phase, and the procurement stage is almost complete. The FEED divided the work into 15 packages, and all have been put out to tender. However, there are two major concerns: price and number of contractors. Negotiations are underway with the contractors for their best and final offers. But preliminary results show the refinery costs are likely to slightly over US $12 billion. Management wants the cost reduced. The current engineering, procurement and construction (EPC) market is relatively soft due to the global recession. Management is asking whether any positive opportunities exist because of the global recession, and whether retendering should be done.

Some analysts say cost savings from retendering may not be as dramatic as executives would like. Matthew Nathan, a Middle East associate director of project finance at UK bank HSBC, argues that the savings on project costs may not be as dramatic as clients would have hoped for. “I would question whether people truly believe contract prices for lump-sum turnkey contracts have come down,” he says. “Our view is that the EPC contractor market has softened, but the prices have not really come down.” (Oil and Gas News, 2009, ¶11)

The second management concern is number of contractors. The FEED divided the work into 15 packages. However, management realizes this is a large number of separate packages, and coordination among the different contractors could create problems. When tendering was done, all 15 packages were separate and no prime contractor role was designated.

Two options that have been discussed were arranging a tender for a prime contractor to manage the work or use an EPCM (Engineering Procurement Construction Management) contract. Another option would be to consider how management of packages can be simplified. A third would be reorganizing and reducing the number of packages and retendering.

Exhibit 3 – List of Packages

A third concern is the completeness of the FEED. The leading practice is to conduct structured technical reviews to gauge the quality and completeness of the design work done during the FEED. These structured technical reviews may be based on the Project Definition Rating Index, peer reviews, or a mix of methods (Gumz, 2008).

Performance to Date

Retendering may take 10 to 12 months. But even if only 5% could be saved, it would result in reduced Capital expenditures (CAPEX). On a 10 to 11B project, 5% savings would be US$500 million.

Challenges

The project schedule can be an area of contention. Contractors frequently complain of clients who demand under budgeted timeframes by as much as 25%.

The number of qualified EPC contractors has been reduced in the last decade through mergers. Even though the recession has decreased global demand for EPC services, the Saudi Arabian market has many ongoing projects that last multiple years. These projects can peak at the same time in construction, resulting in bottleneck. As one European contractor said, “Visas, general bureaucracy, logistics, supplies, a lot of us are going to be fighting for the same limited resources” (Goliath, 2005). Contractors and subcontractors can't always find experienced engineers, especially when relocation to Saudi Arabia for months or years is required.

Decisions

Procurement Strategy and Objectives

The owner's priorities are to reduce capital expenditures to the greatest extent possible, while still building a highly complex full-conversion refinery. They also wish to put the onus on the contractor / EPC to the greatest extent possible, and prefer using lump sum, turn key contracts whenever possible. The Saudi government wants to build capabilities of local firms. The joint venture also wants to encourage local firms to compete for the EPC contracts in line with the JV's policies and objectives.

Organizational Structure of Program

The Project Director has full responsibility for Engineering, Procurement, Construction and Commissioning (EPCC) execution of the Project reporting to the CEO of the JV and supported by a temporary Project Management Team (PMT) for the period of EPCC execution.

The PMT is estimated to peak at 300 plus personnel during the engineering phase and to be approximately 400 plus personnel at the peak of construction phase. Staffing of the PMT will be by secondees from the JV partners supplemented by temporary personnel from staffing agencies.

Risk Management Strategy and Tactics

The following risks have been observed:

1. Lack of a prime contractor may lead to poor coordination and ultimately a longer schedule.
2. The number of packages, 15, may lead to more efforts in coordination and communication.
3. The standard EPC contract has no requirement for the contractor to perform risk management.
4. The joint venture has policies and procedures, but does not have risk management procedures yet in place.
5. Retendering could produce lower contract offers, which would be a positive risk. It would also delay the project by several months however.

Do you see any other risks not in the list above? When considering risks, use a 5 by 5 matrix for liklihood and impact, where 5 is high and 1 is low, as shown in Exhibits 4 and 5 below. Exhibit 5 quantifies the risk in terms of effect on cost, schedule, scope, quality and safety.

Exhibit 4 –Simple Risk Matrix

Exhibit 4– Risk Quantification Matrix

What mitigation(s) would you recommend for each risk?

Potential Unintended Consequences

Are there any potential consequences that need to be addressed as a result of the mitigation strategy taken? For example, retendering could be viewed negatively by an EPC firm, causing them not to bid again. What efforts would you recommend considering in this case?

Conclusions

Risk can have both positive and negative consequences. Good risk management practices can increase the probability of project success, and should be performed throughout a project's life.

An effective case study does five things:

• Leaves important issues unresolved;
• Allows for multiple levels of analysis;
• Captures a tension between courses of action;
• Generates more questions than answers;
• Fosters decision-making thinking (NASA, 2008).

This paper has presented a case study about a very complex project: the engineering design, procurement, and construction of a 400,000 barrel oil refinery. We hope that you have learned about risk on complex projects and mitigation of risk in the design and procurement phases. Decision oriented case studies can be used to analyze risk effectively. NASA's methodology is freely available and should be considered when writing case studies, especially when furthering the understanding of risk management on complex projects.

© 2012, Joy Gumz
Originally published as a part of 2012 PMI Global Congress Proceedings – Marseilles, France