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AM-10-131
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This paper has been reproduced for the author or authors as a courtesy by the National Petrochemical & Refiners Association. Publication of this paper does not signify that the contents necessarily reflect the opinions of the NPRA, its officers, directors, members, or staff. Requests for authorization to quote or use the contents should be addressed directly to the author(s)
For companies that were in the initial phases of projects, there was one question How much less does this cost now? In early 2009, we began to look at project costs in detail and came to the following conclusions: The most that the cost of a typical large project could go down, not including the escalation allowance, was in the range of 20%, but this could only occur if the cost of all goods and services fell simultaneously which would not happen given the lags and leads in pricing.
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The most likely best case was a 10 to 15% cost reduction. The escalation allowance, which in late 2007 and early 2008 was becoming a sizable line item in the total project cost, should be dropped to 0 to 2 percent per annum over the next eight quarters (2009 through 2010).
Over the past year, this estimate has been shown to be reasonably accurate. The past few years have been very unusual in a number of ways. Obviously, the demand for all kinds of construction services boomed, and busted, in most of the world, at the same time. For those of us in the industry, the important thing is not solely to review the past, but to consider what we have learned and how it will affect the future.
Cost Indices
Figure 2 shows various cost indices plotted on a relative scale for comparison. These include the Nelson-Farrar Index (Oil and Gas Journal), the Chemical Engineering magazine index, the Marshall and Swift index and the IHS Cambridge Energy Research Agency (CERA) index. All are for US projects, generally the US Gulf Coast. As shown, three indices show an increase of about 40% from 2002 while the CERA index is much higher abound 80%. Unfortunately, the CERA index is, in our judgment, the most representative of major industrial projects.
Figure 2.
Relative Index
2000 CE
2002 NF
2004
2006 M&S
2008 CERA
2010
All indices had a peak in mid 2008 that was nearly 10 percent higher than the 2008 average.
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The IHS CERA indices are calculated using a portfolio of 30 projects in 18 countries. This is the USGC index. Based on discussions with CERA, the company believes that their mechanism for building the index (which is based, in part, on surveying vendors and other market participants for current cost information) is more accurate than an index which uses a roll up of costs. As experienced cost estimators know, project costs are first estimated on an instantaneous basis that is, it is assumed that the plant can get built in one day with all equipment, materials and labor at todays price. Escalation is added separately. It is therefore not accurate to compare these indices, which are on an instantaneous basis, with public information announcements about project budgets, which do include an undisclosed inflation assumption. In fact, on several projects for which Jacobs Consultancy serves as Lenders technical Consultant, the bulk of announced cost increases were adjustments for future inflation. The downturn in the indices is almost unique. In fact, the long running Nelson-Farrar index has not shown a decline in current dollar terms since 1932.
Given the spread between these curves, shouldnt costs come down more?
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In order to better understand the relationship between labor costs, materials costs and total project costs, it is instructive to look at a cost build up. Table 1 shows a simple breakdown of cost components for a typical project.
Table 1. Project Costs Engineering Major Equipment Bulks Direct Labor Labor Indirects 17% 27% 21% 18% 17%
Here, we have defined bulks to include piping, cement, steel, electrical, instrumentation and similar materials. Direct labor is defined as salary plus benefits, but no overhead charges. Labor indirects include all other costs to keep labor in the field such as tool rentals, accounting, controls, and overheads. First, let us recognize that the total price of each of these components consist of 5 elements. Labor Materials Non Labor Fixed Costs Non Labor Variable Costs Profit
If we take out the profit portion, we then have a reasonable surrogate of the cost to supply the goods and services required to build a plant. Engineering costs are almost entirely labor. In fact, we estimate that labor accounts for about 90 percent of the cost to run an engineering office. The balance is rent, supplies, and utilities. Since we have specifically defined direct labor as being only salary and benefits, 100 percent of this project cost component is labor. Thus, we can easily demonstrate that at nearly 35 percent of project cost engineering at nearly 17% and direct labor at 18% -- is labor. However, there is also a labor component in the cost to supply major equipment, bulk items such as pipe and cement, and in indirect costs. By constructing cost models for various types of equipment and bulk items, we estimate the following cost breakdown for a typical project to be (Table 2):
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Table 2. Project Cost Elements Total Labor Materials Non Labor Fixed Non Labor Variable 60% 25% 10% 5%
In short, we estimate the cost (excluding profit) to construct a plant is at least 60 percent labor. If we were to recognize that there is also a labor component to supply bare materials steel, copper, limestone, etc the labor percentage is even higher. And what does this finding have to do with total project cost changes? Historically, labor costs really do not go down. All companies attempt to keep their best workers in slack times, not cut their salary, this is particularly true with specialized labor such as engineering, specialty trades and technicians. In the Middle East, we understand that some major subcontractors have made major changes in pricing structure to maintain qualified labor forces but they have not cut salaries. It is true that certain hourly bonus payments that were common for labor several years ago have gone, but the percentage is small. There is also some efficiency improvement likely, but more time will be required before this is quantified. Figure 4 shows annual changes in the labor component of the Nelson-Farrar index since 1980. The index is published in current -- dollars of the day terms and shows that labor costs have not declined in the past 30 years. If this is plotted in constant dollars (Figure 5), it can be shown that workers wages have gone down in real terms several times over the period. Thus, in a boom time, construction and engineering wages do outpace inflation. In the bust workers give back.
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Figure 4.
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08
Figure 5.
Nelson-Farrar Construction Index Labor Component, Inflation Adjusted Year to Year % Change
4.00%
3.00%
2.00%
1.00%
0.00%
19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08
1.00%
2.00%
3.00%
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The costs of fixed and variable non-labor costs are also not likely to fall in current dollars over the short term. But if all of these costs do not fall and materials are only about 25% of the total project budget, how did costs increase so much and why have they fallen at all? The answer is profit. Up to now, we have talked about the cost to provide a good or service, including a reasonable allowance for retirement/return on invested capital such as a building. The difference between cost and price is profit. As we will show, profit is the biggest knob in the cost to construct a project. As an example, let us consider an equipment vendors cost and profitability situation in early 2000. In 1999, the average price of WTI was about $19/bbl, up from a low of $14/bbl in 1998 (Source: Platts Oilgram Price Report). Refining margins were poor as were margins for aromatics and olefins. Our review of several heavy equipment companies indicate that the late 1990s/early 2000s was a lean period. For a company producing relatively labor intensive equipment such as compressors or higher end pumps, we estimate the following cost and profit breakdown (Table 3).
Table 3. Equipment Vendor Profile, 2000 Labor Materials NL Fixed and Variable Profit $ 566 $ 236 $ 142 $ 57 $ 1,000
Note that the profit line is relatively meager about 6%. Generally, this is enough to stay in business, but not enough to entice new entrants. Now let us make the same estimate for mid 2008 the height of the market. According to Nelson-Farrar, labor increased by about 40% and materials by nearly 100%. The index does not include data for non labor fixed and variable, per se, so a general inflation figure has been used. But what about profit? If we assumed the same profit level, the price of the same item would increase by about 55%, but that is neither consistent with the data on equipment nor the way markets work. By mid 2008, demand had exceeded supply capability and procurement schedules had more than doubled for some equipment. Some vendors were requesting, and receiving, bonuses to improve delivery time. Given the situation, vendors were obviously making substantially more profit, as the following estimate shows.
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Table 4. Equipment Vendor, Mid 2008 Labor Materials NL Fixed and Variable Profit $ 792 $ 472 $ 191 $ 255 $ 1,710 46% 28% 11% 15%
This estimate more nearly fits what we have seen in the market and, in our view, is a reasonable and consistent price build up. Now let us consider mid 2009 after the market had dropped. As discussed, labor and non-labor fixed costs had increased slightly and materials, on average, had fallen by about 30%. However, backlogs had fallen, delivery times had improved and competition was much more fierce as shown in Table 5. The drop in total price is about 20%.
Table 5. Equipment Vendor, Mid 2009 Labor Materials NL Fixed and Variable Profit $ 824 $ 335 $ 196 $ 76 $ 1,431 58% 23% 14% 5%
If we compare absolute prices, we find that labor and non-labor fixed/variable are slightly increased, materials costs are down by less than $150, but profit on this item has fallen by nearly $200. Thus, we find that the big knob in price changes, and therefore the cost of project is not the cost of labor or materials, per se it is profit. This is even more evident when one considers that a portion of the run up, and decline, in materials costs also represents profit.
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Other than general inflation, we see very little to suggest that project escalation rates used in planning should exceed 2% to 3% per annum over the next four to six quarters. As industry participants, we wish that this were not the case.
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