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Financial Times: Hostile lands empty coffers

By Ed Crooks
Published: December 5 2006 02:00 | Last updated: December 5 2006 02:00

Even by the standards of the oil and gas industry, the $10bn increase in the budget for the Sakhalin-2 liquefied natural gas (LNG) project is a big cost overrun.

The project, in the hostile territory of Sakhalin island off the far east coast of Russia, 55 per cent owned by Royal Dutch Shell, was planned at $10bn, but is now expected to cost $20bn.

But Shell is far from unique in finding that it has under-estimated a project’s costs. High prices for oil and gas, and excitement about the new prospects being opened up by LNG, has led to an investment boom, and the number of projects trying to squeeze into the constrained capacity of the supply industries has led to over-heating.

Uwa Igiehon, director, RBC Capital Markets, says: “In LNG developments, there are very few companies with the capability to engineer and control these projects, and capacity has not expanded while demand has increased very significantly.”

Costs such as the hire of drilling rigs, wages for skilled employees, and raw materials such as steel have soared in recent years.

Of projects worth more than $1bn during 2001-05, only about a third came in within 15 per cent of budget, and about a half were 40 per cent or more over budget, according to figures quoted by Exxon Mobil.

Shell argues that it would be unfair to mark it down as a poor project manager because of the Sakhalin-2 debacle. Since 1999, it has delivered 11 new LNG “trains” – the plants for liquefying the gas that account for a large proportion of the costs of an LNG project – and overall they were on time and on budget.

However, although they are big investments, LNG trains have not generally been the source of large cost overruns. It is at the upstream end, where the gas is extracted, that most of the problems have emerged.

With international energy companies shut out from many of the most easily accessible reserves, they have been forced to venture into ever more hostile environments where projects have taken longer and cost more than first expected.

However, that is not how some analysts see it. Alex Turkeltaub of Frontier Strategy Group, a consultancy, argues that although all energy companies have been subject to the same cost pressures, how they have coped with those pressures has varied.

“Facing this key challenge, the fact is that some companies have responded better than others,” he says. “A time of escalating costs really shows which are the companies with very tight processes, that can execute well and deliver projects on time and on budget.”

In that context, Exxon Mobil’s record stands out. Of its $1bn-plus projects in the past five years, less than a fifth came in more than 15 per cent over budget, and not one came in more than 15 per cent behind schedule.

The secret of this success, according to Stuart McGill, Exxon Mobil’s senior vice president, is “extremely capable people, working in a systemic structure, using proven best practice, documented such that individuals can make available to themselves the historic knowledge of how best to get things done, regardless of where they are at the time”.

Organisationally, that has meant structuring the vast company along global functional lines. “That’s simply answering the question as to how do you need to organise to be the best in this business,” says Mr McGill. “Do you need to have a lot of people who are extremely knowledgeable in detail about the business for which they are responsible, or do you want a lot of people who know a little bit about everything? For us, obviously, the answer to the first question is yes, and the answer to the second question is no. Attention to detail is the best course, because the details are all-important.”

It has also meant phasing projects carefully, to make sure they are “digestible” in terms of the capacity available to deliver them.

As the price of gas falls in many markets, the pressure increases on those companies that have not been able to manage the rise in costs successfully.

Mr Turkeltaub says: “As prices come down, but costs stay high, it will put a squeeze on people who went overboard with their investments, or spent too much on marginal assets.”

Copyright The Financial Times Limited 2006

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