2018, MARCH

““REJUVENATING THE CONTRACT ‘SPINE’ OF MEGAPROJECTS, PART 1” – BUSINESS

TRENDS, HYDROCARBON PROCESSING, HOUSTON

“LEARNING” PAGE

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Ben Crossley - Singapore, and Gavin McLeod - Bahrain

Rejuvenating the Contract “Spine” of Megaprojects - Part 1 Current Contracts

Abstract. Executives and project managers are

grappling with challenging business environments and

a 20-year legacy of overrunning megaprojects. Billions

of dollars are wasted annually from execution

inefficiency, lost production and disputes. The

“medicine” applied over decades is not working. Two

respected consulting firms recently reported on causes

of project failure. They made valid observations.

However, they misdiagnosed symptoms of failure as

root causes. This article is based on understanding

what it takes to build megaprojects. It diagnoses the

failure root cause: business culture. Change is required

to empower competent project professionals, who

prepare well-designed contract “spines” to underpin

business governance and project management

discipline. This contract and related project

development is “preventative medicine” to cure the

reported symptoms, improve project outcomes, and

set in motion a flywheel of sustainable positive

momentum. Enlightened members of current

management circles are ready for change. This article

recommends currently trending actionable and

economic solutions requiring some time and relatively

inexpensive expertise: First, smart, strategic thinking.

Second, commitment to the disciplined work of

preparing usable and simple contracts. Simple is not

lazy, it is the opposite: comprehensive, and yet making

complex projects simpler to understand and execute.

FIG 1-1: Cut the “Gordian Knots” inhibiting contracts

from working, set in motion a positive flywheel

Contracts are not working as the “spine” of

projects. There is an old saying:

“The best place for contracts is in the bottom

drawer.”

Some projects work that way -- until a dispute arises.

Then, the contract is retrieved and interrogated for

favorable interpretations. Sound familiar? Contracts

are misused and misunderstood:

• Thought to have no relevance to the business of

building projects (medical analogy: “unnecessary

medicine”).

• Thought to have the narrow function of

“minimizing liability.” This important for

governance, but only required after the project has

gone wrong (“crisis medicine”).

• Some clients believe that simply by having EPC

lump sum contract terms “if the project fails the

contractor is responsible.“ In the real world, legal

words will not protect clients from failure

(“delusional medicine”) (Ref. Outcomes).

A contract’s purpose is “preventative medicine.” First,

to underpin project governance: high-level assurance

that a project will meet its objectives. This includes

allocation of sufficient time and resources, taking only

commercially prudent risks and liabilities, and setting

control measures. Poor governance in “toxic contracts”

causes bankruptcy (examples: Carillion 2018 UK, Shaw

Group 2012 US).

Second, to underpin project management

discipline: the contract form determines project

relationship, high-level performance obligations and

risk (Ref. FIG 1-5). The contract contents determine

scope, time and quality, HSE compliance, all execution

conditions, requirements and restraints (Ref. FIG 1-6).

These provisions in every major construction contract

mirror the required Body of Knowledge (BOK) of every

project manager (Ref. Project Management Institute

US, Association for Project Management UK).

Clearly, the place for contracts is not in the

bottom drawer.

What is wrong with contracts today? What can be

done? The purpose of contracts and consequences of

poorly designed contracts are rarely explained clearly,

let alone understood. Contracts focus too much on

who to blame and too little on how to get the job done.

An awareness of the current situation and the

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imperative to improve contracts is trending within

innovative parts of the business the legal communities.

For example, General Counsel at GE Aviation recently

lamented:

“For the most part, the contracts used in

business are long, poorly structured, and full of

unnecessary and incomprehensible language.”

(Ref. Burton 2018).

The hypothesis of this article, is that after business

culture change, executives and project management

can restore their ownership over well-designed

contracts. They can empower competent project

professionals who, while taking good legal advice in

context, lead a rejuvenation of contracts, “to make

fresh or new again, to restore to youthful vigor” (Ref.

Business Culture sections). Practical and relatively

inexpensive solutions are within reach (Ref.

Recommendations).

Project overruns are sinking business cases. Recent reports highlight low productivity concerns:

“The industry must confront internal

challenges. In most countries, over the past 50

years, productivity improvements in

construction have been meagre.” (Ref. World

Economic Forum, 2016 pg. 14)

Recent megaproject outcome data has a wide spread,

consistently pointing to major overruns in either cost,

time, or both:

• Average 80% cost overrun and 20 months

delay (overruns in 98% of cases): data on 60 oil

and gas and mining megaprojects (Ref.

McKinsey, 2015 pg. 2)

• Average 35% cost overrun and 25 months

delay (respectively 57% and 64% of cases):

data on 100 power megaprojects (Ref. Ernst &

Young Global, 2016 pg. 4)

Annual USD 29 billion global capital cost overruns are

estimated based on the lowest of the above reports

(35% overrun on 57% projects). The authors applied

that overrun to the forecast annual USD 144 billion

global capital spend for the hydrocarbon processing

industry (HPI) covering refining, petrochemical, gas

processing and LNG (Ref. “HPI Market Data 2018”).

Finally, based on an analysis of past project close-out

data, in FIG 1-2 the authors have quantified three

overrun components.

FIG 1-2: Annual USD 29 billion total global capital cost

overrun total, split into overrun components

Additional Work (10% of overrun total): “nice

to have changes”, due to enhanced functionality or

operating preference. Case example: change of plant

layout according to plant operator’s preference.

Under Estimate (50% of total): “must have

changes”, due to incomplete definition of design or

execution conditions. Case example: inaccurate sizing

of major vendor equipment requiring layout and

routing changes. Though, under estimate is not all

wasted, late change causes inefficiency, and under

estimate impacts the business case.

Execution Inefficiency (40% of total): “absolute

waste”, due to interruptions or deviations to the

planned work sequence and due to delays. Case

examples: client not set up for execution causes

engineering approval delays. And, contractor not set

up for execution causes lack of worksite sequencing

and low productivity.

Return on Investment (ROI) loss from delayed on-spec

production can be astronomical. Therefore, contract

terms include waivers of consequential loss, and limit

contractors’ liability to capped liquidated damages,

normally 10% of contract price. In addition to delayed

on-spec production, reported data shows nearly half

(47%) of projects suffering from significant output

guarantee shortfalls.

Disputes occur on most failed projects, including EPC

lump sum fixed price: Complex and poorly prepared

contracts are open to interpretation (Ref. Contents

section). The contractor seeks a way out of liquidated

damages and cost overruns (reported average 35% vs.

5% pre-tax margins). The client having compensated

expressly instructed changes, maintains that fixed

price, means fixed. The authors estimate

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approximately 1% of project capital cost for low-

intensity disputes without third-party intervention

(USD 1.4 billion annually), and up to 5% in arbitration.

Legal words will not protect clients from failure

consequences. Some clients believe that simply by

having EPC lump sum contract terms:

“if the project fails contractor is responsible …

we won’t pay more than the contract.”

The lost output scenario and others above

show that in the real-world clients have most to lose.

Reported data shows major overruns on 62% of EPC

lump sum projects, which as explained above generally

leads to dispute. Clients should restrict EPC lump sum

contracts to appropriate cases (Ref. Contract Forms

below).

The global USD 12 billion annual capital cost

inefficiency, plus ROI production loss, plus dispute cost

is “absolute waste”. Clearly, both clients and

contractors have a compelling business case to seek

“preventative medicine.”

Overrun root causes and ‘Cobb’s Paradox’. 20 years ago, Martin Cobb advised the Canadian

Treasury investigating “IT” project failures. His well-

known paradox is still valid today. The “medicine”

applied over decades is not working:

“We know why projects fail; we know how to

prevent their failure—so why do they still fail?”

(Cobb, 1995)

Increasing scale, complexity and one-off nature of

megaprojects are not overrun root cause.

Megaprojects seem overwhelming at first sight: scores

of companies, hundreds of engineers, thousands of

documents, tens of thousands of workers. However,

understanding projects, it becomes clear that project

core drivers are repeated. Example: the largest

component of construction manhours (35% to 45%)

and the schedule critical path always involve piping

shop and field welding and installation. That is

standard technology unchanged over decades.

Megaprojects are not destined to fail, they are big and

complex, requiring disciplined project development

and execution (Ref. Barron, 2015 pg. 221).

Respected consulting firms recently reported similar

overrun “root causes” (Ref. McKinsey, 2017 pg. 63,

Ernst & Young Global, 2016 pg. 6):

1. Unachievable cost and time commitments.

2. Incomplete definition of design or execution

conditions.

3. Execution team unprepared, inadequate skills.

Project not set up for delivery with appropriate

procedures and digital infrastructure.

4. Inadequate contract and commercial structures.

Poor supply-chain integration.

5. Inappropriate risk allocation and management.

All these causes are “internal” to the project,

could be cured by well-designed contracts (FIG 1-3),

and the related project development wrapped into the

contract. Overruns from unavoidable and external

events such as change in law are negligible in context.

FIG 1-3: Contract “spine” of governance and project

management

The reported causes are really “symptoms” of failure.

Like every good paradox, Cobb’s apparent

contradiction expresses a deeper truth. The reported

symptoms are valid. However, based on understanding

megaprojects, the following case examples show that

competent project professionals already know all the

reported symptoms, and they know the established

“preventative medicines” that should be applied.

Lessons are not learned: the root cause is deeper than

the reported symptoms.

Symptom and case example 1, unachievable

commitments: overruns occur from attempts to

compress schedule and cost, resulting in major re-work

and delay when attempting the impossible fails in the

real-world. Case example: a nuclear power plant which

was contracted with 5-year schedule v. historical best

7 years. Realistic contract schedules start with past

project references; then probabilistic analysis of an

integrated schedule.

Case example 2, incomplete design: overruns

occur from field changes requiring cut and re-weld of

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fabricated or installed pipe and steel. Case examples:

show productivity falls by more than half during

months of field change (30% ~ 40%). Complete design

starts with client FEED to +/-10% and specifying

minimum engineering competence; contractor

allocating realistic contract allowances for “right first

time” detailed design.

Case example 3, inadequate preservation

execution: overruns occur from inadequate site

storage that causes re-work and start-up delays. Case

example: one project required re-surfacing of all 5,000

installed flanges. Preservation starts with specifying

minimum requirements, allocating realistic contract

allowances, implementing agreed measures.

The root cause of major overruns is “business culture”

characterized by prevailing behaviors and beliefs. This

finding has been neatly stated as follows:

“Modest project ‘screw-ups’ are mostly the

fault of project execution; Colossal ‘screw-ups’

are almost always caused by the business.”

When present, business culture failings, particularly on

client-side, that cause overruns include:

• Grasping short-term gains including perceived

“savings” on competent personnel or accepting

lowest commercial bids without sufficient

technical evaluation; over long-term foresight.

• Lacking the grit for getting down to the “devil in the

detail”, or for facing brutal realities of project

development and execution allowances.

• A “fear impulse” seeking insulation from blame or

responsibility, avoiding tough decisions, remaining

frozen to the perceived safety of the status quo.

When faced with challenging business environments

and contracting implications are not understood, these

cultural behaviors are in respects sane and rational.

The required business culture for successful projects

is long-term, smart, strategic thinking, collaborative,

innovative, tough-minded, brutally honest and down-

to-earth. It is hard but fair, which is more efficient in

the long-term. Example: unduly using market leverage

to impose undesirable contracting arrangements leads

to higher dispute costs. It incubates the single-minder

objective of preparing a robust business case at the

outset – if necessary, killing off unfeasible projects. It

remains relentless committed to achieving all project

success criteria. It understands what must happen,

why, and when. It gets down to the fundamentals

including well-designed contracts. Enlightened

members of current management circles already

practice the required culture and are ready for

widespread change.

Improved contract planning and preparation requires competent project professionals empowered

by the business, applying appropriate techniques.

Some fundamentals are summarized with a project

management emphasis (Broome and Lake, 2017).

The Project Contracting Strategy (PCS) is the contract

planning and preparation keystone. The PCS defines

what scope is proposed in vertical and horizontal work

packages, how to motivate performance and manage

risks with “best fit” contract forms and incentives, who

is available in the market with necessary capabilities

Smart PCS starts in Phase-2 planning the Phase-3

contracts for FEED and technical requirements. These

are essential for delivering stable Phase-4 foundations:

“The quality of the FEED documents will

directly affect the quality of the EPC bids.”

(Baron, 2016)

The completed PCS output is used for Individual

Contracting Plans (ICP) for contracting each work

package.

FIG. 1-4: Project Contracting Strategy (PCS) covering

all project phases (simple example)

The Contract Development Schedule (CDS) manages

the PCS decision gate milestones. Second, it manages

contract preparation milestones for procurement

invitations to bid, and negotiation and award of

contracts. A robust CDS is critical to manage tensions

between the increasingly short times to market, the

time windows to leverage full procurement value from

the market, the internal resource availability, the

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integration of contract preparation with the overall

project development.

The core of the Contract Development Team (CDT)

needs to form at the latest in Phase 2 to develop the

PCS. Full strength team is needed in Phase 3 to prepare

contract documents for bid packages. The CDT team

leadership comprises: the project manager as principal

stakeholder in a well-designed contract; contract

manager as specialist in contract strategy and content;

engineering and construction managers as specialists

in the technical requirements where most overrun

causes originate; project controls manager as specialist

in timelines; legal advisor and business manager as

specialists respectively in terms and conditions and

commercial requirements. Having CDT personnel

follow through into contract negotiation and worksite

execution delivers benefits of building the all-

important expert, committed and collaborative

“project team”.

Improved contract form choices are crucial. Some

senior professionals consider that first-order concerns

are a robust business case and complete design which

will be especially expensive if changed later; therefore:

“We tend to exaggerate the importance of

contracting approach…. Contracting is a

second-order concern.” (2011)

A robust business case is undoubtedly a priority.

Effective execution of that case requires a “best fit”

environment, and that will be determined the contract

form. Clients need to make smart “best fit” choices.

Project specific considerations include: work scope,

and risk factors described in the PCS above, the market

activity of providers, the required schedule, the client

team’s capability, the flexibility to optimize value

engineering or technology adoption potential.

Four fundamentally different contract forms; each

define four “attributes” of a business agreement:

different performance obligations; payment principles;

“first-order risk” allocation; and different working

relationships:

‘Traditional’ Unit Rate (UR): all client

engineering and decision making. Payment by actual

work quantities on BQ rates, or by man and equipment

hours on schedule of rates. Client takes most risk,

except BQ productivity risk.

Engineer, Procure and Construct Lump Sum

(EPCLS): contractor performs everything necessary to

meet defined end states, takes most risks under

defined execution conditions, for a fixed price.

Contractor has the right and the responsibility to

manage works most efficiently. Client maintains a

“hands-free” relationship.

Engineer, Procure and Construction

Management (EPCM), or EPC Reimbursable (PRCR):

Contractor performs the management of works as the

client’s agent, or contracts as EPC to suppliers. Under

both, payment is by cost-plus formula, client takes

most risks, and can maintain an active relationship.

Collaborative / Relational Contracting (IPD):

defines the relationships for parties to work together

to achieve mutual project or framework objectives.

Shared risks and opportunity for example saving on

target price underrun (Ref. Part 2).

FIG 1-5: Four fundamentally different contract forms

(high-level, multiple variants)

“First-order” risk allocation is achieved selecting the

contract form above. Specific “second-order risk”

allocation, for example change in law, is a specialist

topic; in summary: optimize contract allocation to

achieve lowest long-term cost; which generally means

assigning risk to “natural owners” best able to manage

and mitigate or take the benefit and save contingency

if risk does not occur.

Choice of EPC lump sum should be limited to projects

achieving all the following “EPCLS qualifying criteria”

for the potential benefits of this form to be delivered:

1. Clear and stable work scope. Preferably +/-10%

FEED design; at minimum unambiguous basic

engineering inputs (example: certified P&ID,

HAZOP), and end states (output guarantees).

2. Clear and stable execution conditions,

requirements and restraints.

3. Project risks identified and commercially prudent.

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4. Client wants “hands-free” relationship, not

intruding on contractor’s right to manage works.

5. Qualified EPCLS providers are interested in the

market.

6. Bid time is available and sufficient for stable and

competitive pricing.

EPCLS is be the predominant form reported to used on

53% of projects. Reported data showing 62% major

overruns indicates that on many megaprojects it is

unrealistic to meet all qualifying criteria. Alternatives

to EPCLS are required.

Fortunately, several alternatives to EPC lump sum are

available in regular use, as briefly outlined below:

• EPC Management (EPCM): is reportedly used on

25% projects with lower design definition and

higher risk. Experience shows that with smart-

design of cost-plus formula, contractor’s cost,

time, HSE motivations can be aligned with client.

Reported data showing 78% major overruns

indicates how difficult it is to design an effective

formula and use on higher risk cases.

• Early Contractor Involvement (ECI): use is trending

with innovative clients including a recent oil major

megaproject. Client employs one or more

contractors to develop design and execution plan,

as basis of second-stage execution. Efficiencies

result from leveraging execution expertise in value

engineering and advanced work planning in the

project shaping stage.

• Mixed engineering and procurement reimbursable

(EPR) and EPCLS: is reportedly used on 12%

projects with only 8% major overruns. Efficiencies

result from reimbursable work scope definition.

During EPR client risk is manageable by “open-

book” procurement and engineering is only 10%

project cost. Second stage EPCLS construction

contractors bid on work scope now clearly defined

in EPR phase.

International model contracts (FIG 1-5) offer

efficiency promoting advantages over many

specifically drafted contracts, including the following:

balanced “second-order risk” allocation, usable plain

language, less ambiguity after years of fine-tuning, user

familiarity, and available off-the-shelf. Collaboration

and a project management “spine” are built into some

models:

“NEC is designed to act as a definition of what

good project management around a group of

people should look like.” (Dr. Barnes,

Association of Project Management, Founding

Chairman, 2011)

Improved contract content needs to be usable by

the project team. Well-designed contracts are

comprehensive, and yet make complex megaprojects

easier to understand and implement. In essence,

contracts need a clear structure mirroring the project

activities and to satisfy two simple criteria:

1. For matters where there is certainty, they must

offer unambiguous instruction;

2. For matters that deal with uncertainty, they must

offer clear guidance on how it will be handled. It is

rarely practical to anticipate every incident or

uncertainty

FIG 1-6: Contract Pinnacle Structure

Contract Terms and Conditions (TC) whether

specifically drafted by legal or by a model contract

applied to the project will define the contract form (FIG

1-5). TC need project team oversight to ensure that the

PCS decisions on form, risk, payment principles and

relationship are correctly applied.

Contract Technical Requirements (TR) justify

the most focus and resource from CDT. Based on an

analysis of past project close-out data, most overruns

and disputes stem from TR. The biggest opportunity to

improve outcomes lies with better-designed TR.

Business people need practical business instruments

that support successful business outcomes. What

someone does not understand s/he will neither plan

nor implement. Practical guidelines for well-designed

content include following:

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1. Contracts should be structured so that users know

where to find relevant information. An effective

technique is to mirror the main project activity

breakdowns and workflow, so it’s logical for

project people (FIG 1-6).

2. Concise so users don’t get lost or distracted.

Overdue “house-keeping” is required to clear out

unnecessary complexity and consolidate concise

standard documents. Case example: engineering

document specifications comprised five unlinked

sections, totaling hundreds of pages. The result is

abundant ambiguity. A series of mid-project

workshops are required to determine what is

required for hand-over, and what would be

burdensome inefficiency. Consolidation should be

a priority action:

“Both the volume and size of contracts have

grown dramatically over the last 30 years and

this has been accompanied by greater

complexity.” (Ref. Cummins, 2018)

3. Precise and complete for appropriately described

requirements. Requirements shall be expressed in

plain-language actionable terms: who does what,

when and where; not in abstract legalese.

The business case for simple plain-language contracts

is trending within innovative parts of the business the

legal communities. The case includes: Saving time to

market and costs of needlessly dragging negotiations;

Project execution team who are often multinational

can use the contact down to supervisor level (most

times it understandably stays in the “bottom drawer”);

Reducing disputes caused by ambiguity in complex and

poorly managed technical requirements, meaning that

each side can normally find one interpretation

supporting their position. Case example: GE Aviation

recently completed a three-year program changing

terms and conditions to usable plain-language, and

reported the following results:

“The contract was then presented to the

leaders of the digital-services business. It was

well received, to say the least…. Plain language

has saved significant amounts of time and

money” (Ref. Burton 2018).

Simple does not mean incomplete or lazy. In fact, it’s

the continued use of unmanaged performance

inhibiting complex contracts that are lazy and

constitute a bigger business risk.

Takeaways and Recommendations. The estimated

annual USD 12 billion global capital cost inefficiency,

plus ROI production loss, plus dispute cost is “absolute

waste”. Rejuvenating contracts and the related project

development, is key to improved outcomes. Use of

well-designed contracts is trending. After the current

overruns, potential benefits, and the solutions have

been clearly explained and understood; enlightened

members of current management circles are already

for widespread business culture change:

"No problem can be solved until it is reduced to

some simple form” - J. P. Morgan (1837 - 1913)

Recommended practical improvements steps are

neither difficult nor expensive in relative terms:

1. Client organisations need to buy-in as primary

drives in their supply chain. Starting by analyzing

causes of any existing or potential overruns. After

consultation, design appropriate improvements.

2. Implement improvements with stakeholders,

including, as applicable:

a) Core personnel and capabilities: establish or

train company centers of competence in line

with in current trends and techniques.

Replenishing competencies lost over the past

decades is a top priority for many clients.

b) Contract form: familiarize project

management with current options. Implement

smart “best fit” forms applicable to specific

project circumstances

c) Contract content: Overdue “house-keeping” is

required to clear out unnecessary complexity

and consolidate concise standard documents.

Prepare usable plain-language contracts with a

focus on the technical requirements.

FIG 1-7: Economic and practical “preventative

medicine”

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Part 2 Continues with: Contracting trends and

revolutionary new strategies examines the

potential of collaborative contracting, described in the

foreword to a new book as follows: “The goal of

everyone in the industry should be better, faster, more

capable project delivery created by fully integrated,

collaborative teams” (Ref. ‘Integrating Project Delivery’

- Fischer, Ashcroft, Reed, Khanzode, 2017).

Literature Cited - listed by publication date

‘Why simplify your contracts?’ - Tim Cummins, CEO of the International Association for Contract & Commercial Management (IACCM), January 2018

‘The Case for Plain-Language Contracts – Shawn Burton, General Counsel GE Aviation, Harvard Business Review, January 2018

‘Guide to Contracts and Procurement’ - Broome and Lake, Association for Project Management, 2017

‘Reinventing Construction: A Route to Higher Productivity’ - McKinsey Global Institute, February 2017

‘Shaping the Future of Construction - A Breakthrough in Mindset and Technology’ – World Economic Forum, 2016

‘Power and Utilities Megaprojects: Formulas for Success’ - Ernst & Young Global, Power & Utilities, 2016

‘The Oil and Gas Engineering Guide’ – Hervé Baron, Dec 2015

Further reference is available to online subscribers at

http://www.hydrocarbonprocessing.com/magazine/archive

Authors

Ben Crossley is Director and founder of

Energy Contract Solutions specializing in contracts and

procurement in Singapore. Ben provides front-line advice to

clients and EPC contractors on downstream oil and gas and

power generation megaprojects. Ben facilitates regular

training on ‘Project Development and EPC Contract

Management’.

Gavin McLeod is Senior Staff Operations

Specialist at Chevron Inc. specializing in commissioning and

systems completion, currently on assignment to Bapco

Refining Company in Bahrain. Gavin’s expertise and

specialist interests include hydroprocessing technology,

project implementation efficiencies, team development and

organizational dynamics.

Disclaimer: The views, information, and opinions expressed

in this article are solely those of the individual authors and

do not necessarily represent the official policy or position of

any third party, including an author's employer.