Existential crisis drives EPC consolidation

Nov. 6, 2017
The evolution of the engineering, procurement, and construction space can be traced back through a seemingly never-ending chain of mergers and acquisitions. Firms have joined forces through the years as a means of survival as competition increased and projects became more complex. In the oil and gas industry, this activity has recently accelerated in response to new market realities.

Matt Zborowski

Assistant Editor

The evolution of the engineering, procurement, and construction space can be traced back through a seemingly never-ending chain of mergers and acquisitions. Firms have joined forces through the years as a means of survival as competition increased and projects became more complex. In the oil and gas industry, this activity has recently accelerated in response to new market realities.

Capital budgets are markedly lower than they were in 2014 given lower-for-longer oil prices. Many of the integrated oil and gas companies and state-owned firms have shifted their strategies or reshuffled their portfolios. While offshore development has dropped globally, new petrochemical and LNG hubs have emerged due in part to inexpensive shale gas, and major refining projects have shifted eastward to accommodate growing petroleum product demand in developing countries. However, projects that do receive the greenlight are scrutinized by owners with little money to spare.

"The fact that you're competing against a global mix of players is a critical one that makes these mergers even more necessary."
-Khush Nariman, partner, McKinsey & Co. Inc.'s downstream operations and strategy practice

The dramatic oil and gas industry changes come with the continued backdrop of an EPC space that's beleaguered by inefficiency and high costs. Advancements in EPC technology have at best only kept pace the with the growing size and scale of major oil and gas projects across the upstream, midstream, and downstream segments. Rapid improvement is needed if many of the EPC firms wish to be involved in the next generation of projects.

"Without a doubt there is a trend in the EPC space towards consolidation," said Erin Roberts, Ernst & Young LLP Americas leader of engineering and construction, during an October discussion with OGJ. He noted that while each of the notable EPC deals during the recent wave of M&A activity was done for a different strategic objective, some consistent themes have emerged.

"First, the oil and gas market was one of the largest end markets served by E&C companies before the downturn and therefore was prone to a high number of market entrants," Roberts explained. "Historically there have been low barriers to entry in the E&C market, which is not a capital-intensive business and therefore allowed for a very crowded bidding table. Early on, the complexity of oil and gas projects drove a more cost-plus contracting model. As the market got more crowded, oil and gas EPC contracting became much more prone to fixed-price contracts."

Khush Nariman, partner in McKinsey & Co. Inc.'s downstream operations and strategy practice, expanded on Roberts' first theme during a separate discussion with OGJ, noting that the big western firms now face rising EPC competition from the East. "The fact that you're competing against a global mix of players is a critical one that makes these mergers even more necessary," he said. Nariman believes "the true competition is really the Chinese and Indian EPC firms," many of which "are focusing on lump-sum contracts, which are often awarded on the basis of lowest cost." he said.

Contractors have less bargaining power than oil and gas companies, Roberts said, as the capitalization of an E&C firm is much less stable than that of an integrated oil and gas company. "E&C firms are trying to rectify this competitive disadvantage through consolidation-either to reduce competition or increase bargaining leverage," he said. "The theory is that less bidders means lower likelihood of 'dumb-money' at the bidding table, meaning there's less chance of someone at the bidding table being willing to go fixed price or bid too low.

"Finally, when dealing with global oil and gas companies, vertical integration is seen as key-a single entity that can provide a one-stop shop, an integrated offering, which would be expected to result in a more efficient delivery," Roberts said. "The history of the 'bid-design-bid-construct' model is evaporating in favor of integrated EPC. Integrated delivery is a consistent mantra in these megamergers."

Seeking vertical integration

Before the recent trend of mergers among the biggest EPC firms serving the oil and gas industry, E&Y's 2014 study-"Spotlight on Oil & Gas Megaprojects"-illustrated just how bad project execution had become. Analyzing 365 projects each with capital investment of more than $1 billion across the upstream, LNG, and pipeline segments, the study found that 64% of projects experienced cost overruns and 73% experienced schedule delays, resulting in nearly $500 billion in incremental costs. The average budget overrun in the US, Africa, Asia, and Europe was more than 50% of the original budget. In the Middle East, projects overran budget by 68% on average, and in Latin America, the average overrun was more than 100%.

Jose Luis Blanco, an associate principal in McKinsey & Co.'s Philadelphia office, said the "unexpected surprises" of cost overruns and write-offs have unsettled the industry. "As a result, every single major EPC and engineering and construction company has declared over the past 3-4 years operational improvement programs" hoping to optimize and gain certainty in the way they deliver projects. Roberts said the impact of poor project execution "has increasingly been borne by the EPC contractor" as fixed-price EPC contracting has become more common, resulting in "significant losses by the industry over the past 2 years."

The integrated project delivery model is supposed to benefit EPC firms, Roberts explained, by combining service offerings "between wholly owned companies performing various aspects of project delivery-from [front-end engineering design], to construction engineering, to construction services-to reduce inefficiency and disputes from occurring throughout the project delivery supply chain."

Pedro Caruso, partner in Bain & Co. Inc.'s oil and gas practice, noted that firms have sought integration into the equipment space, as "most of these EPCs will claim that they already do the full engineering-to-procurement end." That union is meant to reduce costs from a user standpoint, making the design and construction of plants cheaper. "With the engineering side now knowing very, very well the equipment part of the equation, they should be able to optimize and integrate. A lot of the time there are redundancies on both sides that are not needed, so by looking at it in a single way, you can reduce some of those redundancies. But also, the theory goes that because they're using similar types of equipment and they're building the same stuff over and over, they just get better at it.

"On the midstream side, you hear a lot of noise around more 'plug-and-play-type' designs where you are the user and you don't have to design everything you sell. As the industry moves away from bespoke solutions for everything to the more standardized pieces, vertical integration allows companies to provide combined solutions that are cheaper and faster to deploy."

Seeking leverage vs. owners

By offering integrated project delivery to integrated oil and gas companies, consolidated EPC firms are hoping to boost their leverage in the owner-contractor relationship. But the changes are yet to translate to increased margins for contractors, Roberts said. "Given the scale of these contractors and the globalization of the marketplace-[as] foreign contractors are teaming and competing-there continues to be a significant level of competition resulting in tight margins and increased risk for contractors. Given the capitalization of contractors, this model is not sustainable and is at risk of causing business failures, which has negative ramifications for the entire oil and gas investment chain."

Caruso emphasized it's still a buyer's market. "It's the owners who have the power," he said. "They know it, and they're enjoying it because they all remember the way it was before the crash. Some even resent the cost-plus model and its unintended consequences. Owners are now passing as many risks down to the EPCs as they reasonably can. Given that competition among EPC firms continues to be fierce, they are more likely to agree to higher levels of performance guarantees compared to what they would have agreed to just 3-4 years ago."

"When dealing with global oil and gas companies, vertical integration is seen as key-a single entity that can provide a one-stop shop, an integrated offering, which would be expected to result in a more efficient delivery."
-Erin Roberts, Ernst & Young LLP Americas leader of engineering and construction

Blanco said research indicates that a change in contracting approach is a critical component to changing the EPC space for the better. "We have found so many examples in which the owner and the contractor have an unhealthy relationship in terms of always pursuing a zero-sum game. That ends up generating wrong behaviors, and that's when you end up with overruns, deviation, and in the end both parties are not where they want to be." He said, "We need to change that if we really want to boost our productivity and be in an industry that promotes innovation and collaboration.

"Where I have seen these contractor relationships work is when the contractor has taken a longer-term perspective on the relationship with the client," Blanco said. A longer-term perspective, he explained, involves the contractor being a "true partner" instead of just a service provider so the contractor can help "deliver this project for the next 10 generations of projects." In his experience, Blanco observed that such an approach "provided transparency on their base costs and what it really cost to deliver a project. They could talk openly about margins, contingencies, and overruns as well as share the upside [and not just be] penalized by the downside. When these discussions happen between an owner and a contractor, what I see is longer-term relationships flourish."

Integrating isn't easy

A primary driver of consolidation, as Roberts mentioned, is the desire by EPC firms to reduce the hiccups that sometimes come from ill-fitting working relationships between contractors during a project. However, amid the declarations of future cost savings and improved project delivery that follow the announcement of a promising merger, the process of combining into a single entity often comes with growing pains.

Mike Whalen, Deloitte LLP managing director, Mid Americas capital projects consulting, shared his experience with OGJ after recently working on megaprojects with EPC firms that have either recently completed a combination or were in the middle of one. "When the integration is more challenging, inefficiencies can be introduced into the project," he said. "For example, when personnel from the acquired EPC are slow to adopt or have not been fully trained on the use or functionality of the acquiring company's project management systems, tools, and databases, they sometimes revert to using off-line tools-like Excel, for example-which can lead to data integrity issues and be disruptive to the project."

He said, "On one project there was a relatively nimble and agile contractor merging with a highly centralized, very prescriptive acquirer, and the clash of cultures played out in front of the owner. And it did affect the relationship" between the combining contractors and the owner. In another instance, there was a merger where the buyer recognized that the company they were acquiring was "nimbler, more agile, and decentralized," so the buyer let the acquired company operate largely to the same degree as it did before the merger. "And in that instance, I think it actually enhanced the overall relationship with the owner because the owner did see broader scale, a deeper supply chain, and an ability to squeeze cost out of more leverage" as a larger, combined entity, he said.

Whalen also mentioned an instance where a merger took place following a successful joint venture between an EPC firm and a major trade contractor where savings and efficiencies came from supply chain integration. An equipment supplier that merges with an engineering firm seems to work better from an owner's perspective, he said.

On a broader level relating to cost savings, Ray Ballotta, Deloitte partner for mergers, acquisitions, and divestitures, said, "When two companies come together they're going to be focused on organization, supply chain, things that can move the needle first." Then those companies "focus on items that have maybe a longer lead for synergy capture." Whalen said "efficiencies are hard to ring out" when it comes to aspects such as engineering, but adopting proven modularization can help accomplish that goal.

Merger case studies

Among the biggest EPC firms, Caruso noted that the merger of Technip SA and FMC Technologies Inc. "holds a lot of potential because of the integration of equipment and engineering. The French guys are really good on the engineering side and the FMC guys have some very good equipment." But it's still too early to see it in the market, he said.

In the firm's third-quarter earnings call, Douglas J. Pferdehirt TechnipFMC chief executive officer and director, said he expects his newly combined firm to land more integrated contracts in 2018. "We believe these future integrated projects will be larger than those awarded thus far. They represent a diversified mix of operators, some of which will be repeat customers at the integrated model," he said. "And they expand the regional diversity of the integrated approach."

Pferdehirt said, "The advantage of [Technip and FMC] having worked together now for almost 3 years initially in the alliance and joint venture [Forsys Subsea] and more importantly now as a single entity, TechnipFMC, allows us to take that work we've been doing as it matures through the FEED stage, which typically takes 12-15 months and then into the [final investment decision] stage, which typically takes 6 months. We now have this backlog of integrated FEED activity that has the opportunity to convert into integrated [engineering, procurement, construction, and installation] projects."

Another recent example of a merger that captured vertical integration is SNC-Lavalin Group Inc.'s 2014 purchase of Kentz Corp. Ltd., an engineering and construction specialist that had 15,500 employees operating in 36 countries at the time. That deal combined SNC-Lavalin's FEED aptitude with Kentz's construction management, commissioning, and operations capabilities. It created a group of 20,000 employees with expertise in the LNG, pipeline, shale gas and oil sands, offshore jacket, and steam-assisted gravity drainage segments.

"While cost savings can come from better utilization of the labor force, both on the overhead and the engineering side, there's also in quite a few cases a bit of a scope component" to these deals, said Caruso. Some firms are hoping to diversify risk by reducing their dependency on one segment within the oil and gas industry and spreading their capabilities into others.

When GE's oil and gas division merged with Baker Hughes Inc., the companies touted the creation of a new "fullstream" services firm-one with a presence in upstream, midstream, and downstream.

Wood Group PLC, now Wood PLC, reshaped its identity and diversified its service offerings through its acquisitions of Infinity Group in 2015 and Amec Foster Wheeler this year. Wood Group's reputation was built on its offshore engineering and design expertise, but Wood PLC now has a new suite of downstream capabilities.

The addition of Infinity marked Wood Group's entry into the US petrochemical, refining, and gas processing segments, complementing its downstream presence in Australia and Asia Pacific. Infinity's services include mechanical construction, fabrication, project management, turnarounds, maintenance services, heavy civil works, site preparation, and electrical and instrumentation services.

Wood Group's downstream exposure was amplified by its $2.7-billion purchase of AmecFW, itself the product of the $3.2-billion merger of Amec PLC and Foster Wheeler AG in 2014. The addition of AmecFW-and its 55,000 employees operating in more than 60 countries-reduces Wood's upstream dependence to 55% of revenues from 75-80% before the deal, enabling Wood "to have a sector and geographical spread," Andrew Stewart, Wood chief executive officer of asset solutions, Americas, told the Houston Chronicle after the merger's completion. "Having that natural balance with downstream is helpful," he said.

Jeff Reilly, Wood executive president of strategy and business development and formerly AmecFW's president of business development, explained to OGJ that AmecFW brings to Wood Group "strong refining and services capabilities coupled with global range for EPC offerings that can be built off an existing client base." He added, "The depth of our capabilities extends beyond EPC and commissioning to operations and maintenance where pull through services can expand our offerings to the next phases of asset life. There are additional synergies when linking Wood Group's plant automation and process controls capabilities with AmecFW's EPC capabilities. In combination, both our EPC and plant services offerings are even stronger."

Blanco noted that owners have been under pressure in recent years "to become more efficient not only in the way they deliver projects but also in the way the manage their assets." That means service providers that can offer more diverse end-to-end services and act as "thought partners" on improving project delivery as well as operations over the long term, he said. "That's a compelling value proposition that owners are going to be very happy to accept."

Looking ahead

Blanco said consolidation in the EPC space is being done in a way that will create "stronger entities that have end-to-end product services-or portfolio services-for the owners and are able to manage these interfaces and interdependencies and manage risk better than they've done in the past." While that process of optimizing operations within EPC firms started before the recent wave of consolidation, the mergers of recent years will "only accelerate that process," he said.

Nariman said the merged companies will have better systems, tools, technologies, and talent because joining forces allowed them to "high-grade everything," resulting in a positive impact for overall delivery. Ten years from now, Nariman believes the industry will view the recent string of EPC mergers as having made "the industry a lot more robust and a lot more efficient."

"We have found so many examples in which the owner and the contractor have an unhealthy relationship in terms of always pursuing a zero-sum game."-Jose Luis Blanco, associate principal, McKinsey & Co.'s Philadelphia office

Roberts noted that, given commodity prices, the largest construction opportunities in the near term remain in the midstream and downstream spaces-but particularly in North American midstream. "A couple of midstream contractors are serial acquirers who have been building scale and capabilities over time to tackle larger and larger projects and are experiencing significant growth," he said.

"There is a tremendous backlog of oil and gas transmission projects that were held up over the past couple of years either due to the prior administration [and regulatory hurdles] or due to a wait-and-see approach to the commodity markets. These projects are focused on building out transmission of oil and gas from the shale basins across Texas, Mexico, Canada, and the Northeast," Roberts explained. Midstream companies have sought to meet this demand by acquiring companies to fill out niches in the construction value chain.

"In the downstream market, some contractors are definitely expecting the next wave of downstream FIDs in petrochemicals and LNG," Roberts said. However, he warned, "Many downstream oil and gas contractors have been hurt financially by the risks they assumed in many of the large EPC projects. Some of these have taken large losses on projects resulting in reduced financial strength, which will make winning and executing the next projects more difficult. These losses can be attributed to a low level of productivity in the construction phase of the projects, which is caused in part by labor availability. M&A activity is not expected to slow as this reduced financial strength drives a need for rescue and cost cutting. I expect a couple more large mergers in the industry to be announced in the coming months," Roberts predicted.

"When the integration is more challenging, inefficiencies can be introduced into the project."
-Mike Whalen, Deloitte LLP managing director, Mid Americas capital projects consulting

Diminishing labor productivity remains a primary issue for the EPC space overall going forward, particularly in the US. "This can be sourced to a tightening and aging workforce," Roberts said. "The industry has responded by increasing its investment in recruitment and training but also by increasing the advancement of construction technologies such as prefabrication, modularization, robotics, drones, and data analytics to try and stem the productivity decline. But the fruits of that investment have yet to pay off."

Blanco also expressed his concern about a shortage of craft labor in the US and specifically on the Gulf Coast, where LNG and petrochemical projects abound. "There's a renewal of skill craft labor that isn't happening at the pace it's supposed to happen, and it's something that's widespread across the industry. You have, for example, a whole generation of welders who have been doing the job for 30 years, and right now you don't have the same kind of renewal of young people willing to learn and the craft and take it forward. That for me is just going to become another burning platform for firms to become more efficient-to really understand that they need to become more productive to partially offset the loss of talent and shortage of skilled labor," Blanco said.

Caruso added, "The amount of people who have been let go and the expertise that has been lost through [the process of EPC consolidation and the downturn] is just tremendous."

The other thing to keep in mind, he said, is that "a lot of operators have lost complete departments. If you go to some of these refining companies and even the EPCs, they have let go of a lot of capabilities in different places."

Additionally, with distillation unit and conversion capacity work shifting east, there's been "a migration of American expertise to Asia," Caruso noted. He believes EPC firms that have maintained expertise will have more power going forward.