Off Take Agreements
I want to continue, and finish, the EPC project delivery system I started in the October newsletter. One part of the EPC project delivery system the Owner has to arrange are the off-take agreements. These off-take agreements apply to any industry, not just oil and gas. The off-take agreement governs the sale of the product from the project. These are agreements that have to be in place before funding can be obtained. Lenders will not provide financing unless they can recover their money which comes from the sale of the product.
The off-take agreements spell out when the product has to be delivered. If, the off-take start dates are missed it can be costly for the Owner, as he may have to buy product on the market to cover his contracts for the product he was supposed to be making. It is therefore imperative that there is a good schedule that can be met. As an EPC contractor you have to know what these off-take start dates are as there may be penalties in the EPC contract for missing these dates. As an EPC contractor you should be looking ahead and planning to meet the off-take dates. As the days get closer you need to be looking to see what you need to do to make the dates. If the dates cannot be met, the Owner needs to be advised as they will have to make other arrangements to buy product on the market to meet their supply contracts.
How Much To Finance
With an EPC contract the owner knows how much money he has to finance at the beginning of the project. He gets a cost from the EPC contractor to design, construct, commission and startup the facility. Using this number, the Owner will do some type of risk analysis on the cost and determine how much of a management reserve is required. This plus the EPC estimate is what they will fund.
In the contract between the Owner and the EPC contractor there are some things the Owner needs to define and provide. The Owner will provide the plant site, scope, specifications for the plant, quality, and project schedule. If the Owner has existing facilities he may have people who can determine the above, otherwise, he may have to hire an experienced consultant to provide the information.
The Owner will negotiate a contract with the EPC contractor and payments will be made in agreed installments. Because payments will be delayed due to the normal accounting process the EPC contractor has to have funding available to perform the EPC contract.
The Owner has to arrange for EPC funding. In North America when you buy a house you have to get a loan from the bank, what we call a mortgage. If you go to the lender with a large down payment of about 20% you can get better terms than when you go to the lender and you only have a 5% down payment. When you have a larger down payment that means you are taking a larger risk and therefore the lender will give you a better deal on the loan. This is the same with an EPC contract. The lenders are not in the business of losing money therefore, they have to be in agreement with the risk allocation between the Owner and the Lender. A bankable contract is a contract with a risk allocation between the contractor and the Owner that satisfies the lenders.
The lenders will focus on how well planned the project is, what are the chances of additional costs and or time, bonding by the contractors, past performance of the contractors, experience of the contractors and how much security the contractor is providing. The lenders access the risk of using the proposed contractors and based on this risk will determine the amount of equity the sponsors will have to provide. The less comfortable the lenders are with the EPC contractors, the greater amount of equity that the sponsors will have to provide.
Financing is usually secured by the assets of the project itself. The financing for the project has to be paid off over several years and it is paid off through the revenue generated by the project. Once construction starts money is paid out, and continues to be paid out until startup when revenue starts to come in and goes to pay off the financing. This is why startups are so important to the Owners as they want to get the revenue stream flowing to pay off their financial commitments.
To obtain financing the Owner has to prove that the project will actually make money and the revenue will pay off the financing over certain number of years. One of the methods of determining the viability of the project is the rate of return which you should all be familiar with. The financing can be recourse or non-recourse. On large projects they will typically use a limited recourse with the limits defined. With recourse financing, the lender can go after the Owners other assets to make up the loss. In the US houses are purchased with non-recourse financing and in Canada they are purchased with recourse financing. So, in Canada if you fail to pay off your house loan or mortgage the bank or lender can go after your other assets as well.
Since the Owner has to start paying down the loan as soon as possible they are always interested in startup and the pressure gets more intense as the date approaches. The financing will be based on these dates and to miss the date can cause chaos with the financing plan. This is why you will find penalty clauses in your EPC contracts regarding a late start up and turnover. It is important to keep the Owner appraised of the start-up process, any potential problems, and the likelihood of meeting the date.
As the lenders try to minimize their risk and they will analyze a variety of factors and the EPC contract as a whole. They will require a fixed completion date, liability clauses, and a lump sum price. For this reason you will find liability clauses in your EPC contracts. Brand-new technology is very risky. There is always a chance it will not work, therefore, with an EPC contract there should be very limited technology risk. That being said, this is how some companies develop the competitive advantage, by being the first on the market with something new. Ifthere is some type of technology risk, management may have to put in a management reserve to allow for this risk. This would be their own money up front.
Case Study: I worked on one EPC project were the Owner was building a new plant, with a first of it’s kind. We were part of the joint venture. We were the engineering contractor and the lead partner. Working with the Owners, we gave them a lump sum price of $70 million for the facility. Along with the Owners, we would go to venture capital groups to try and sell the project to get the additional needed funding. One of the things the Owner did at the meeting, was to hold up the EPC contract as proof they had a fixed lump sum price for the project. This was a big selling point and the Owner eventually got enough funds to build the plant.
With any project there has to be some type of output guarantees. The rate of return and the funding terms, are based on these output guarantees. If the facility is an established process, the process guarantee should be known. If it is a new process, the output guarantees have to be developed before the funding can take place. With some technologies especially new ones, developing the output guarantees can take several months to resolve. The Owner may have to hire a consultant to protect their interest in the development of the process guarantees.
As I said previously, there will be liquidated damages for both delay and performance. This means that for every day the contractor is late, they will have to pay the owner a certain dollar value. This could be in the range of hundreds of thousands dollars per day. As well, if the new facility does not perform as a specified, there will be liquidated damages for that as well. The EPC contractor or its parent company, has to provide security of some form, usually done through bonding. The contractors are very careful with liability issues, as this could destroy their company. Ideally, there would be no caps on liability, however, given the nature of EPC contracting and the risks to the contractors involved there are almost always caps on liability. Because of the cash flow requirements from the operating facility, the Owner will put restrictions on the ability of the contractor to claim extensions for time and additional costs. This is the nature of lump sum contracts.
Owners Love It
The EPC contract delivers all the requirements I talked about above, risk allocation, liability, single point of contact, fixed completion dates, lump sum, and performance guarantees. For these reasons, EPC contracts are used on a variety of oil and gas projects. These can be projects of a small amount, like $50 million or very large amounts of $1 billion or more. To summarize, the EPC project delivery system is similar to design build but it’s for complex projects. Complex projects involve multiple disciplines. With EPC we have the Owner directing an EPC contractor who directs a group of subcontractors. The EPC contract, is the least risk to the owner as he has performance guarantees, a completion date, and a lump sum price. It is the fastest project to construct as the EPC contractor can fast-track as he needs to, to meet his obligations. It has a quality design as the EPC contractor has to meet the performance guarantee. It is the most cost effective as the EPC contractor is always trying to save money. The more money he saves the more money he makes. But, that has to be a balanced between being cost-effective and quality. On large complex projects, the owner may not have the people to manage, nor the infrastructure, nor the knowledge to carry out the project. Therefore, they use an EPC contractor who can handle the complexity. That is the EPC project delivery system.
Case Study: I worked on one EPC project that was new technology. We had performance guarantees from the main vendor who’s equipment was the heart of the process. When we started up, the vendor’s equipment could only reach 85% of it’s planned output. We operated the equipment at 85% while the vendor did more research on the process. It eventually took them 18 months before they could come up with a solution to get the equipment to operate at 100%. Penalties were negotiated with the vendor. In situations like these you do not want the penalties so great the vendor goes out of business. There has to be a reasonable agreement.
We hear a lot about fast tracking projects and with an EPC contract this is possible and easy to do. With fast tracking we start the actual construction on one portion of the project before the design is complete. An example would be starting the foundation construction before the final internal components of the building are complete. Another example of fast tracking is to depend on the contractor’s knowledge and give him a rough sketch. The items will get built from the sketches and the final drawings will be based on redline drawings you get from the contractor. This works in small situations, but you would not want to try the sketch trick on a big job. Fasttracking is not a method of the project delivery, it is just a management strategy of getting something up and running a lot faster.
Case Study: We had a project to replace an old electrical substation with a new modularized substation. The new substation had a delivery of one year. We had to have the substation in time for a scheduled shutdown, and were under the gun from the start. The only way we could meet the schedule was to buy the substation before we had final project funding. The substation was purchased with cancellation clauses, and we purchased it with basic design information, not detailed information. We worked out the details as it was being designed. We did not get final funding for another four months, and if we had not fast tracked the substation order we would never have met our startup date.
You have to be careful of what you’re going to fast-track. You have to look at other contracts that could be affected, and if the fast tracking has a negative effect on other contracts you may not want to do it. The substation, was a fairly straightforward project and we did not anticipate running into major issues with it. Fast-tracking is more successful on these types of projects. Fast tracking may be one small portion of an overall EPC contract, or it could include a lot of items. It usually comes into play with long lead items. You have to look at each item and decide if and how it can be fast tracked. To determine what should be fast tracked visit with your team members and see what problems they see or are anticipating.
This is the end of the articles on projected delivery systems. There are several different project delivery systems available and each project has to be looked at to see which project delivery system will work best for the Owner.
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