Lumpsum Contract Pain

By William Cunningham

At the start of this year, Italian engineering, procurement and construction giant Saipem delivered some disturbing news. A review of its backlog of projects led to the company concluding that its adjusted EBITDA for the second half of 2021 would be €1 billion (US$1.1 billion) less compared to its outlook delivered in October 2021.

These figures were staggering, even for a company like Saipem, which has become accustomed to financial losses over the past few years. The reasons given for these losses, which eventually translated into annual net loss of US$2.8 billion, were even more interesting. Saipem claimed that some of its onshore EPC contracts had been significantly impacted by increasing costs of material and logistics, as well as cost and supply challenges with some offshore wind projects.

Crucially, global cost escalations were impacting Saipem more than most of their contemporaries because its sizeable backlog contained projects light on reimbursable agreements. In layman’s terms, this meant that when costs skyrocketed in 2021, Saipem was forced to pick up the tab.

However, heavy losses are old news. Following the previous major market downturn in 2014, low oil prices, reduced capex and an increased focus on cost-cutting by operators meant that contractors had to be very aggressive if they wanted to win contracts and retain market share.

With operators also keen to transfer risk through lumpsum contracts, this resulted in some prominent victims, such as Chiyoda and McDermott, who in 2019 were forced to swallow total cost overruns of about US$2.6 billion on the Cameron LNG project in the U.S. This ultimately led to Chiyoda seeking refinancing and McDermott filing for Chapter 11.

Losses were mounting across the onshore EPC market, forcing several contractors to rethink their strategies before the Covid-19 pandemic. KBR was first out of the blocks. Following combined net losses of more than US$1 billion between 2014 and 2016, the U.S contractor gradually began descaling its lumpsum oil and gas business, finally announcing in June 2020 that it was completely exiting lumpsum oil and gas contracts. Fellow U.S. contractor Fluor was next in line, initially reducing its lumpsum exposure in 2019 and then announcing in September 2020 that it was exiting competitive lumpsum energy contracts.


Risk-averse Market

Although not all players have taken things to the same lengths as KBR and Fluor, a risk-averse environment now prevails among EPC contractors, where the general focus is now on improving margins and diversifying away from the oil and gas industry. While the latter will be a long road, the first goal is being dealt with as a matter of urgency, particularly since Covid-19 driven project delays, supply chain constraints and a range of extra costs have served to exacerbate matters.

Although not all contractors are exiting lumpsum work, several are seeking to mitigate their participation in these kinds of contracts.

Saipem is, unsurprisingly, taking action. The Italian contractor now intends to adopt “greater commercial selectivity” on onshore EPC contracts going forward and will seek more cost reimbursable elements to contracts, particularly when it comes to procurement.

With further Covid-19 flare-ups reported in China, and the war in Ukraine continuing to rage, supply chain issues and cost volatility appear to be here to stay. However, high oil prices and global demand for energy security are also creating a favorable market environment, which is expected to lead to strong growth in new orders in 2022 and 2023. The nature of these contracts will reveal whether EPC contractors have slipped back into their old habits or if the era of caution will prevail.

William Cunningham is a senior research analyst at S&P Global Commodity Insights