Inflation Squeezes Margins, Delays Projects

By Jeremy Bowden

In a story from Issue 6 of Breakbulk Magazine, we investigate how spiraling costs on contracts agreed some years back are causing acute pain points for breakbulk handlers, and how some industry professionals are urging greater cooperation to share the burden and avoid the cancellation of projects.


Planning ahead is never easy, especially when it involves large amounts of capital spent over many years to achieve a major project – like many of the projects involving the breakbulk sector. Recently, inflation and rising supply chain costs have played havoc with many major project calculations, often bid and won in times of far lower cost pressures.

According to Offshore Energies UK’s Supply Chain Manager, Graeme Rafferty, supply chain operating costs in the UK offshore sector have risen 10-20 percent over the last year or so, based on a recent survey. A range of factors are responsible for this, depending on the company, but raw material costs in particular have “spiraled”, with 4 out of 5 companies saying they had been negatively affected.

“Tier one contractors and SMEs are reporting difficulty in getting certainty on long term costs,” he said, which is making fixed price bidding risky. “Commodity price volatility as well makes it very difficult to agree on long term pricing.” OEUK Market Intelligence Manager Ross Dornan added that there had been a particularly dramatic change between now and the height of the pandemic in 2020. “Only 2-3 years, and it’s a completely different cost environment.”

Aditya Munshi, Product Portfolio Officer at Independent Project Analysis (IPA), agreed that supply chains had been stressed for three years now due to price pressures. Based in Washington, Munshi said that a recent survey of 50 large industrial companies (big oil companies and refiners, chemical producers and miners) showed lead times for process equipment (tanks, columns, etc.) supply are up 30 percent since the pandemic. “So 50 weeks from purchase order to delivery, has now extended to 65-70 weeks,” with transport and logistics factors playing a key part in the delay, he said.

The biggest bottlenecks are in electrical equipment, which is partly due to competition from new renewable energy projects as electrification and the transition to renewables picks up speed. “Deliveries of electrical equipment now takes 60-75 percent longer than 2-3 years ago. For example, a transformer now takes 60-70 weeks to be delivered, compared to 35 weeks before.” He said the impact was pretty global, but Europe and Asia tended to be worse than the U.S., with Russia’s invasion of Ukraine adding extra pressure in Europe.


Trickle Down Effect

The rise in costs is now moving from equipment and materials to services, labor and construction. Up to late 2022, engineering services costs and labor held fairly steady at near 2021 levels, with all the rises due to equipment and materials. Now vendors are short of skilled people, and there are delays as a result. “EPC houses, vendors, are all struggling to find and retain talent,” Munshi said, which is resulting in delays and upward pressure on prices.

A rise of 6-7 percent in engineering and construction rates is expected this year in some parts of the world, with equipment still rising too but not so fast. “There’s also a lot of fear in the market; commodities are still high, so capex is still there, but EPCs are in terrible shape to ramp up after the pandemic.”

Munshi said the logistics element, on the other hand, including breakbulk, was “getting better,” with freight rates down this year. He said freight was included in the 30 percent cost rise since 2020, making up about 8-10 percent of the total delivered cost. Inflation impacts the breakbulk sector in various ways, including factors like port congestion and import backlogs, labor availability, and fuel prices, among others, according to Jaymie Freeman of Cargoos Logistics. These factors squeeze margins, delay orders and extend lead times.

The IPA research showed that this year only 20 percent of owners are finding it difficult to get freight on board, compared to 40 percent last year. Similarly, now only 20 percent of owners are reporting limited resources at ports, compared to 45 percent in 2022. And vessel availability is even better, with 25 percent of owners now reporting no difficulty, compared to 60 percent in 2022. “This is based on our survey and suggests cost pressures in the freight sector are easing off a bit… Part of [the inflation issue] is freight but there’s much more to it, rates have gone down, but price pressures are still there.”

Munshi said looking ahead a year, supply chain inflation was expected to continue, with a forecast of 5-7 percent cost estimate rise overall - although this may be revised upwards due to higher fuel costs. “Over the last three months, crude has risen sharply to the mid-US$90s per barrel - as crude goes up, everything goes up.”


Projects Delayed and Canceled

While inflation can squeeze margins for those in the breakbulk sector, it can also result in major project delays or cancellations – which can reduce the total volume of work in the market. The IPA research showed 27 percent of companies had postponed at least one project in the last year.

Munshi thought this may rise over coming months “because bids for current projects are so high and the cost of capital has gone up significantly – especially if raising money from market. The hurdle (interest) rate is going up and costs are going up, so business cases are moderating. Business feedback is still broadly positive, but it has moderated.”

To some extent, any fall in volume in the market should dampen demand and reduce bids but only if vendors survive. “The cure for high prices is high prices”, Munshi said, “but maybe not this time. There is something different this time and that’s new renewable energy, which is often driven by public spending and incentives” such as the IRA (U.S. Inflation Reduction Act), and EU renewable programs. This is expected to drive capital spending not seen in previous cycles, so preventing a softening in inflation and project lead times. “This is demand that wasn’t there before,” he added.

The situation is seen at its most extreme in the offshore wind sector, where at least one major project (the world’s biggest, Norfolk Boreas, off the east coast of England) has been canceled, costing Vattenfall US$455 million. The Swedish energy firm, which was building the project, said it would cease working on the wind farm because its costs had increased by more than 40 percent, making it unprofitable.

At least one other UK wind farm is thought to be at risk, while the latest UK offshore auction round received no bids. In the U.S., Ørsted - the world’s biggest offshore wind producer - has been forced to incur significant additional charges and delays related to offshore wind projects, leading to huge write-offs and sharp falls in its share price.

OEUK’s Dornan said the Vattenfall offshore wind failure and cancellation was a prime example of where companies simply could not make projects work in the current cost environment, with a range of factors - materials, supply train constraints and logistics – to blame. OEUK’s Rafferty added that a failure “to recognize the wider inflationary environment - in the case of wind within contracts for difference, and in other cases within contracts – is causing real damage and holding back activity.”

Munshi also noted that the chemical sector in Europe had been particularly badly affected, partly due to high energy costs, leading to a lot of shutdowns and delays.

Dornan acknowledged that the breakbulk sector is crucial for the offshore energy sector in the UK over coming years: “We’ve got 2,000-3,000 wind turbines to be installed this decade alone. Dozens of offshore platforms need removal, although there are only a few installations. There have definitely been some upward revisions to topside removal costs and heavy-lift needs within the oil and gas sector, as well as wind.

He expressed concern that project delays and cancellations would eventually mean less work in the pipeline, which could see breakbulk vessels moving to other regions where the renewable work is being done/subsidized – for example, the U.S. or EU - or where hydrocarbon taxes are lower.


Margins Squeezed

In other cases, where projects are not canceled, and contracts have already been signed on a fixed price basis without inflation clauses in them (sometimes years in advance), the rising prices have been squeezing margins and causing considerable disagreement between developers, contractors and freight forwarders. EPCs contacted for comment in this article declined, citing the sensitivity of the issue and NDA clauses in contracts with developers and others.

What is clear, is that inflation is a huge challenge for the project cargo industry, putting margins under pressure and adding a renewed focus on reducing costs. Until recently, most vendors and contractors did not foresee the inflationary pressures, leaving many without provisions to offset against this risk. If fuel, labor and other costs rise, at least some of this needs to be passed on to customers through higher rates, otherwise margins are squeezed, and little or no return can be made for the shippers and freight forwarders.

However, OEUK’s Rafferty said SMEs, logistics providers and suppliers were having difficulty discussing the issue and passing on any of the costs to their customers. “In many cases there’s no mechanism to ask for an inflation linked rise in cost. If their customer has agreed fixed term rates and is focused on costs, then they don’t want to accept any increases. But contractors can’t afford to proceed at a price agreed up to two years ago.” He said recent offshore workers’ strikes in the UK North Sea had made the situation more difficult.


Adapting to a New Reality

However, as inflation rises, logistics companies are implementing strategies to manage its impact on their businesses. These include optimizing their supply chain, adopting new technologies, and renegotiating contracts with their carriers, according to Cargoos’ Freeman.

OEUK’s Rafferty said inflation was changing the nature of contracts. “Some companies, especially large tier one contractors, previously would go for lump sum models, but they are now shying away from that and trying to negotiate inflation mechanisms into contracts.” He said alternative types of performance-based contracts were also expected to become more popular. These offer closer relationships between customer and supplier and switch the focus to value and away from purely cost.

Munshi added that fixed price commitments had completely disappeared over the last two years: “Vendors are too risk adverse now. Sometimes teams are not able to secure quotes that last longer than a week now or even a day sometimes,” compared to 1-3 months previously. He said contract provisions linked to “current market pricing” – tracking market indices for major cost components - were becoming more common. “Not everyone, but most project owners are accepting this now to get vendors to bid. If the contract terms are not relaxed, then they’re not getting any bids,” he noted.

Munshi said that EPCs were bidding into contracts 30 percent higher than last year – “but we don’t see prices have gone up that much in just the last year – they don’t want to take the risk so are pricing in contingencies. They can do this when there are so few skilled resources.”


Pickier Vendors

Rafferty said that the experience of being squeezed, combined with an increase in some offshore activity due to higher oil prices, meant contractors, freight forwarders and others were being more selective about the work they took on. “Companies are saying, when a tender does come out, do we want to bid on this. Is this the type of customer we want to work with?”

Munshi agreed that project developers must work more closely with their suppliers and take on some of the price risk as they were normally better placed to handle it. “Increasingly, there needs to be reasonable agreement on sharing pain if markets move. These projects are taking longer and costing more, and so owners have to be more flexible and cooperative – they don’t want vendors to go under."

Rafferty added that project developers can no longer pass price risk right down the supply chain. “There needs to be a pause to reflect on what’s gone wrong and the types of contracts used. A balance of risk and reward is required, which would involve more flexible contracts, with incentivization models and shared models where both can gain.” He said recently he had seen examples of suppliers and contractors looking at different contract models to see which one would be the best win-win for both parties.

But while there may be disagreement between contractors within major projects, there is a broader danger that the cost pressures may result in fewer projects overall, reducing the amount of available work over coming years. Challenged by conflicts within projects and delays and deferrals of projects themselves, breakbulk providers could be in for a rough time.


TOP PHOTO: Vattenfall's Ormonde offshore wind farm, UK. CREDIT: Vattenfall