Costs rise despite economic slowdown, analysts say

Despite the global recession, costs of constructing upstream facilities have reached a record high, as have those for designing and constructing refining and petrochemical projects, according to IHS and CERA.

Dec 17th, 2008

By OGJ editors
HOUSTON, Dec. 17 -- Despite the global recession, construction costs for upstream oil and gas facilities have reached a record high, as have those for the design and construction of refining and petrochemical projects, say IHS Inc. and Cambridge Energy Research Associates (CERA) in their most recent upstream capital costs index (UCCI) and downstream capital costs index (DCCI).

Similar in concept to the consumer price index, the UCCI and DCCI are proprietary measures of project cost inflation. They provide a benchmark for comparing global costs and draw upon IHS and CERA proprietary databases and analytical tools.

Continued high activity levels and tightness in the upstream services and equipment markets across the board led upstream costs to increase 9.2% in the past 6 months—a rate 3.2% higher than the previous 6 months.

The latest increase raised the IHS-CERA UCCI to 230 points from its previous high of 210. The values are indexed to the year 2000, meaning that a piece of equipment that cost $100 in 2000 would cost $230 today.

Driven by high demand and escalating fuel prices, cost increases reached even higher points during July and August, but have moderated as of the end of the third quarter.

"Hidden in these substantial increases are the first signs of what may be a change in direction," said Daniel Yergin, CERA chairman and IHS executive vice-president. "Moderation in the last 2 months of the third quarter was a response to the unfolding financial crisis and the spending cutbacks and points to a precursor to a downward turn in the direction of the UCCI."

Of the seven localities tracked by the IHS-CERA UCCI, Asia, Russia, South America, and Africa saw the highest levels of cost change, registering increases of 11.8%, 10.3%, 10.3%, and 10.1%, respectively.

"Variations in cost escalation across regions over the past 6 months were most influenced by local activity levels, inflation, currency exchange rates, and steel costs," added Pritesh Patel, director for the capital costs analysis forum for upstream.

The increase was driven by a continued high level of upstream oil and gas activities and a marked increase in the cost of steel and subsea equipment. Upstream steel costs have grown by an unprecedented 32% from the first quarter to the third quarter because of raw material and scrap metal costs. Although significant compared with the 10% increase seen in the previous 6-month period, this increase is in line with the UCCI report issued 6 months ago.

Subsea equipment demand remains strong, with more deepwater developments planned—especially in South America and West Africa. Steel cost increases have added pressure to an already tight market, with an increase of 14% in the past 6 months, and there has been no change in lead times since the first quarter.

"This tight situation and the attendant cost increases are generally expected to persist in the short term, as the market response in the oil and gas markets is primarily 'wait and see,'" added Patel. "However, there are forces at work that could create significant downward pressure on costs in the midterm, and possibly even the short term."

Patel noted that in certain market segments, supply and demand for services have begun to achieve balance and the global nature of the services and equipment industry means that oversupply in one area can quickly be used to address demand in others. In addition, the global economic crisis is putting the breaks on global oil demand, which was already decelerating in response to high prices.

The DCCI rose to 187 points from 176 over the past 6 months—an increase of 6%. The values are indexed to the year 2000, and the index has risen 87% since then, meaning that a project that cost $100 in 2000 would cost $187 today.

"At the end of the third quarter, the impact of the slowing economy had just begun to affect the cost of construction materials," Yergin said. "General construction activity, even in the US, remained relatively strong and only slightly lower than total spending in the previous year, because strong nonresidential spending continued to offset the losses from residential construction. At the same time, demand for energy-related projects remained at high levels, continuing to constrain supply. However, the effects of the recession and the credit freeze will likely change the picture considerably in the months ahead."

"While some markets had significant increases, engineering and project management and labor both showed only small increases in the past 6 months, with any local inflation being offset by the recent strengthening of the US dollar," said Jackie Forrest, lead researcher for CERA's capital costs analysis forum for downstream.

Cost increases have been sustained by ongoing demand in the energy sectors; steep increases in the cost for carbon steel material, impacting the cost of manufactured goods made from carbon steel (structural beams, piping, and equipment); and high energy prices —West Texas Intermediate oil pricing averaging more than $120/bbl during the second and third quarters of 2008.

Of the 18 localities tracked by the DCCI, China and the US Gulf Coast saw the highest levels of cost change in the past 6 months, registering increases of 8.5% and 7.9%, respectively.

"Although the current credit crisis did little to slow construction costs this period, we expect growing credit issues and slower global growth to lead to lower costs for constructing downstream projects in the next period," Forrest said. "Credit issues will almost certainly have a growing and noticeable impact on future general construction activity in the United States and other regions."

Forest said, "It is important to note, however, that governments around the world are working hard to restore liquidity, and it still remains to be seen how far these measures will go in bridging the gap and providing the funding needed for the long list of general construction projects currently planned globally."

Construction levels for planned downstream projects are almost three times busier than the recent past, and although CERA does not expect all of these facilities to be built, the level of construction activity for downstream projects is projected to remain relatively strong until at least 2010 as existing, committed projects are under construction.

Past 2010, downstream project activity levels are expected to slow, with lower refining margins and lower expectations for economic growth working to slow plans for yet-to-be-started downstream projects.

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