Too Big To Fail? Disproportionate risks in “mega”-projects

The booming demand for LNG and large-scale construction projects worldwide can hide a potentially fragile supply chain of contractors, whose finances cannot support unpredictable changes in the development of these projects. The failure of these companies has a direct impact on subcontractors and suppliers in the shipping industry.

LNG - a case in point

The global energy market has become accustomed to the successes of the LNG industry, and the steady stream of export and import terminals springing up across the globe. Their contributions to providing flexible energy sources for the future is well-documented, offering wider choice and value to a growing array of end-users of gas.

But, the LNG contractors’ market has suffered its first big “jolt” of the year, with US infrastructure developer McDermott International Inc., filing for Chapter 11 in January 2020 saying that it had experienced pressures due to its participation in two US projects, Freeport LNG and Cameron LNG. McDermott said its finances were "significantly strained" by the projects, making it "difficult to maintain a timely balance between cash received from customers and cash spent on projects". 

Should McDermott have been better prepared?

Its easy to argue that McDermott should have been more cautious about its extensive involvement in more than one large and long-running LNG project. As new LNG projects have become more abundant in recent years, it is perhaps becoming clearer that their large scale and long lead-in times could be creating particular risks for contractors.

Freeport LNG and Cameron LNG are now exporting LNG cargoes on a regular basis, and are highly successful ventures. But, the lead-in times for such “mega-projects” are certainly daunting. US projects have to pass a rigorous approval process by the Federal Energy Regulatory Commission (FERC), for which they must pay. Contractors participate in LNG projects through tenders based upon a broad assumption that projects will proceed roughly as planned. But, the work doesn’t start when the first shovel is picked up, or the first tractor engine started. Labour and materials have to be booked, computations of costs and extensive site inspections undertaken. Any delay once this process starts will lead naturally to escalation of costs, and that's when the trouble can start.

Navigating volatile markets

The LNG market is an excellent example of the risks at play here. Gas market conditions can change significantly over the life of an engineering project, altering the economics for all stakeholders.

Back in 2013, when global LNG prices were a good deal higher, market conditions were encouraging for new LNG export projects. But the slide in gas prices during the intervening period has made some project backers, and their banks, more wary of investing. The result has been a more cautious investment climate for LNG production, leading inevitably to a slowdown.

The structure of LNG mega-projects, with high sunk and upfront costs, exposes contractors to significant risk when compared with, for example, oil production. LNG is produced at trains, or liquefaction plants, and most projects comprise more than one. If market conditions deteriorate, planned additional trains can be reduced or postponed, meaning that even if a project goes ahead, it may do so at a reduced pace. All of this creates uncertainty of cashflows and therefore adds risks for contractors. By contrast, it is much easier, and cheaper, for an operator to cancel an oil production project, since it may involve merely plugging a few wells and moving drilling equipment.

The ripple effect

It’s not only big players like McDermott which could be affected. Problems can trickle down to subcontractors, such as technology, equipment or fuel suppliers or operators of shipping services to this sector. In the case of McDermott, it has emphasised that it expects all suppliers will be paid in full, indeed, that is part of the logic of implementing the Chapter 11 process. Not all contractors are, or are required to be, so scrupulous. Contractors can always manage their own cash flow by pushing their liquidity issues onto their suppliers. The Multi Purpose shipping market is a good example of this, with key players in this sector impacted for many years by the inability of key project cargo clients to pay in a timely manner for their services. They, in turn, put pressure on key suppliers (such as the bunker market) to help cover this cash flow gap. 

What next?

Any significant change is clearly reliant on a level of restraint that can be applied to bidding for such contracts (something that seems to have been sorely lacking in other contracting sectors, as the UK has seen in recent years). However, moving forward, there is a possibility that contractors may shun big LNG projects due to what they may perceive as disproportionate risks. Or, they may start to impose their own solutions, asking for better security such as full cash-in-advance terms to cover more upfront costs, or even “take-or-pay”-style contracts for contractor services, rather akin to what we have seen for many years in the LNG trading market.

Whatever the effects, the problems sustained by McDermott should be recognised as a timely warning, which highlights a higher-than-normal risk for contractors from mega-projects. The LNG, oil and gas upstream sectors, upon which all energy traders and shippers ultimately depend, need a healthy contractors’ market to ensure the orderly fulfilment of badly-needed production projects over the long-term.

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Published on 3 Feb 2020

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