Saudi Oil & Gas Engineering, Procurement, Construction Term Paper

Introduction

The growth of the Saudi Arabian economy can largely be attributed to the oil industry of this country, especially petrochemical production and petroleum refining. In 2007, oil products constituted 88, 1 percent of the total export ( 1 The United Nations, 2010, p. 322). At the given moment, Saudi Arabia is among the fastest-growing economies in the Middle East. This is as a result of the rapid growth in population and large scale projects that have been emerging over the last few decades.

Domestic consumption has been affected by the rise in oil prices. Currently, this country is the largest oil producer in the world. In 2007 Saudi Arabia produced 12,8 percent of the world’s oil output ( 2 Olah, Goeppert, & Prakash 2009, p. 38).

The country produces so much oil that is capable of meeting its domestic needs. The surplus is normally exported to overseas markets. Saudi Arabia has become is currently the biggest producer of oil and as a result, it plays a critical role in determining the demand and supply of the product. Due to the high level of dominance that Saudi has in the oil industry, the country plays a critical role in the determination of the world oil prices.

On the whole, oil production is the main sector of the country’s economy. These products play a critical role in the growth, development, and control of Saudis economy. However, the industry is highly mechanized and as a result, it does not require high human labor. This, therefore, states that it does not provide enough employment to the local people. It should be noted that Saudi oil-producing companies occupy leading positions in the world. This argument can be illustrated with the help of this chart.

The production of crude oil reached a peak of 9.9 million barrels per day in 1980 and began to decrease (4 Federal Research Division 2004, p. 183). The production was later hindered by the war between Iran and Iraq in 1985 (5 Federal Research Division 2004, p. 183). Since that time the country’s oil output began to increase. The country was able to increase its share in the global oil industry after the international embargo on Kuwaiti and Iraqi oil; in 1991 average daily output was 8.5 million barrels per day (6 Research Division 2004, p. 183). Since that time, Saudi Arabia has turned into the most important oil producer in the world.

The government of this country aims to other oil reserves located in this country such as Shaybah Field which is near the border with the United Arab Emirates (7 Cordesman 2003, p. 81). Additionally, one can mention such reserves as the Abu Hadriya or Khurais Fields. Each of them can significantly contribute to the production of oil in this country. Moreover, it was announced that the country will attempt to raise its production level to a record-breaking height, namely 12, 5 barrels per day (8 Weisenbacher 2009 p. 642). Although many analysts are skeptical about these plans, they indicate that the government of Saudi Arabia intends to become the main leader in the production of crude oil.

Although production levels decreased slightly at the end of 2008, the government officials are still convinced that the country’s oil-producing facilities will be able to achieve the expected results; moreover, they even claimed that the country can reach a new oil production level, namely 15 million barrel per day after 2011 (9 The Kingdom of Saudi Arabia, 2011). Thus, one can say that oil exploration and production is one of the top priorities for Saudi Arabia.

In order to achieve these very ambitious production objectives and meet the increasing demand for energy throughout the world, the government will invest billions of dollars in the development of new fields. Moreover, they intend to invest in infrastructure in an effort to expand the capacity of their oil-producing facilities (10 Weissenbacher 2009 p. 642). The global economic crisis which manifested itself throughout the world presented the country with new challenges. This recession resulted in the decreasing demand for oil throughout the world (11 Oxford Business Group 2010, p 30). However, this decline was only temporary, and currently, the global demand for oil is on the increase (12 Oxford Business Group 2010, p 30).

Saudi Arabia is willing to pursue the development of the oil and gas sector of the economy. These projects are important for the local as well as the global economy. For instance, the Saudi Arabian Oil Company intends to open new export refineries at Yanbu and Jubail.

The increasing competition in the construction industry and decreasing pricing will help the government of Saudi Arabia to reduce expenses ( 13 The Kingdom of Saudi Arabia 2011, unpaged). In March 2009, the government of this country expressed intentions to invest about $60 billion in oil infrastructure (14 The Kingdom of Saudi Arabia 2011, unpaged). These plans indicate that in the future the role of the oil industry may become even more important for this country.

The economy of Saudi Arabia has grown together with the establishment and development of its state. The building of the state has been equipped by oil sources in the modern institutions of the system of government and has worked to empower the economic status of the country. This has also led to new project ventures which bring revenue to the country and its citizens. Today, Saudi Arabia is known for its enormous reserves of oil and gas.

However, an export-led economic diversification effort will soon help the Kingdom become a significant global producer of value-added industrial components and manufacturing inputs from aluminum and fertilizer to high-tech fiber-optic cables ( 15 The Kingdom of Saudi Arabia 2011, unpaged).

Major Projects Opportunities

As has been said there are a great number of projects which are of great importance to the oil industry of this country. Examples of these projects include Herath, Khursaniyah Hawiyah, and Shaybah Expansions that were done by ARAMCO, the largest oil and gas company in the world. Furthermore, one should not forget about those project which are going to be implemented in petrochemical sector, for instance, Sharq, Yansab, Saudi Kayan, or Ar-Razi Expansions (16 Seznec & Mirk 2010, p. 35). They are of great significance to such petrochemical company as SABIC (17 Seznec & Mirk 2010, p. 35).

Several projects are going to be executed, for instance, oil refinery will be constructed in Jubail, Jazan, and Yambu (18 Oxford Business Group 2007, p 116). In addition, each of the new refineries will be designed keeping petrochemical products such as benzene, xylene and paraxylene. The effective functioning of these facilities will depend on the choice of contractors. This issue will be discussed in the next section.

Engineering Procurement and Construction (EPC) contracts

An EPC contract deals with engineering services. The contractor acquires everything for the project on behalf of the owner. They also take the building work. Due to its nature, this project is run and managed by the contractor. The cost, risk and control are borne by the contractor away from the owner. EPC contractors take direct agreements with other parties to necessitate the construction process (19 Loots and Nick, 2007, p 15).

In an EPC contract organization, the contractor has responsibility to design and construct a building. This gives a single point means of accountability. In case a problem results, the project company will deal with one party for accountability (20 Loots and Nick, 2007, p 14).

Proper comprehension of EPC contract conditions and clauses usually helps the project to be achieved and be monitored through the right management with regards to the requirements of the project. This will help the project to run smoothly and meet the standard requirement. This usually avoids disputes and conflicts that may happen in the process of the contract. The customer should have good understanding of the contract terms and articles before starting the project.

EPC is a common type of contracting style where the contractor makes a plan for the project and purchase the materials for construction. There are some instances whereby the contractor will assume the risks of the project. According to this type of agreement, the contractor is completely responsible for design and development of a project (21 Huse, 2002, p. 17). In turn, the customer is obliged to provide accurate functional specifications and requirements which the contractor has to meet. As a rule, EPC project are called turnkey because the client does not have to do any work on the project. In this case, both the customer and contractor must ensure that every requirement is clarified; otherwise, they may have many legal disputes.

EPCM Contracts

According to an EPCM (Engineering, Procurement and Construction Management) contract, there is agreement with the company to give engineering, purchase materials and equipments necessary for the project and have management in the construction site. The project owner makes agreement with other companies and other subcontractors so that they can render their services in the construction process but they work under the supervision of the EPCM contractor.

The whole project is usually directed and supervised by the owner who in turn takes all the risk that is incurred in the process of construction (21 Loots and Nick, 2007, p. 5). Both EPC and EPCM contracting are the common types of contracts in the construction industry. The project owner has to come up with a decision depending on the state of risk he is willing to acknowledge, the expenditure, limitations and his own skills and experiences will help to choose the best method for a project.

There are several differences between EPC and EPCM contracts. In this case, special attention should be paid to the obligation of both partners. According to EPC agreement, the contractor performs the following tasks:

1. The design of the project;
2. Management and administration of the project and provision of strategic and programming services
3. Moreover, this side of the agreement has the responsibility to monitor procurement and construction work, management of tender. These are the main responsibilities that this party has (22 Loots and Nick, 2007, p. 5).

In comparison with EPC agreements, EPCM contracts are normally more expensive. The owner is supposed to pay the subcontractors directly for equipments, materials and on-site works. This side has the responsibility to reimburse the EPCM contractor for the expenditures that this company had to make. In this case, we can speak about labor costs, supervisory services, as well as the bonuses specified in the contract. The amount that the EPCM contractors charge will depend on the risk that will be assumed in the process of the contract.

An EPCM contract is particularly suitable in those cases when it is necessary to redesign the project or when the customer did not fully specify functional requirements. Such agreements are particularly suitable under those circumstances when the construction company want to insure itself against possible legal disputes. In those cases, when the client is able to determine the functional characteristics of the construction facility, this side will normally prefer an EPC agreement (23 Gloria 2011, p 50). In this case, the main responsibilities are shifted on the contractor.

An EPCM contract can be preferred by parties for several reasons. Very often they do so because they cannot to obtain an efficient contractor that would accept the terms of EPC contract. Moreover, in many cases, the owners may not be able to define the main capabilities and features of construction facilities. So, this side of the agreement may be forced to accept the terms of EPCM agreement.

EPCM contracts are used when expanding large engineering facilities, construction projects. For instance, among them one can single out petrochemical facilities or oil refineries. The main peculiarities of these projects that they are likely to be redesigned even in the course of construction. These changes may not be very significant but they are very costly. EPCM contracts are not used in public and social projects. The only exceptions are those cases when the project can be completed by multiple contractors. These are the main differences these models. This chart illustrates the main components of EPC model.

EPC Model

An EPC contract is a form of a contract whereby the contractor is responsible for all the elements of the project. The contractor is responsible for designing, procuring, engineering and construction. In case of EPC contract, the contractor accepts to give the keys of the specially made project to the owner at an accepted amount like it happens in contracts where a builder gives keys of a building to the buyer.

In Saudi Arabia EPC contracts are becoming the commonly used ways to conduct projects but both parties need to know the constituents of the contract in order to have the best project (25 Schramm, Maibner, and Waidiger 2010, p 33).

While conducting EPC contracts, people need to be very keen on management so that the company that is taking the project makes conditions and outlines the design and framework like expenditures and expenses so that they can have the necessary standard.This demands specifications of performance according to the productivity of the project, planning and maintenance of the project. The interactions between various sides of an EPCM contract can be described with the help of this chart.

EPCM contract deals with specialized services which have totally specific risk sharing and different formal costs.The key difference is that under an EPCM contract, other parties construct the project and the EPCM contractor is not the builder or constructor. The EPCM contractor acts as a mediator on behalf of the owner of the project and he has to necessitate close connection and have positive reactions between the owner and the other contractor so that the works can meet the required specifications. Each step in the project is a connection and agreement between the owner, the contractor and the vendors or expatriates (27 Schramm, Maibner and Waidiger 2010, p 35). The following table shows the differences between EPC and EPCM, and the main principles which govern these approaches.

Risk Allocation in EPC and EPCM

In EPC, the contractor provides the owner with a single point of responsibility, communication and coordination related to the major activities involved in the project. All the risk is allocated to the contractor because he is the overall in the project (Quick MBA, 2011). This usually leads to a likelihood of high contract prices that comprise contingencies and mark-up to hedge against risks like performance, time extension, cost increase and potential loss (29 Loots and Nick, 2007, p. 15).

The EPC contractor deals with the owner and a large number of sub-entities during the execution of the contract and he has to make sure that those entities comply with the conditions outlined and adhere to delivery requirements. The contractor assumes full responsibility for realization of the project incurring all risks involved (30 Clifford 2009, p 30).

In EPCM, the contractor assists the owner to manage the whole project. Under this contract, the project is owner managed and the cost risk is borne by the owner and not the contractor (31 Clifford 2009, p 11). The owner has to approve the EPCM contractors managing complex contracts and the cost risks of the project are taken by the owner, any cost over runs and savings are taken to the account of the owner.

Determining Which Model to Use in the Oil and Gas Industry Major Projects

The decision taken while selecting contractor has a significant role in the delivery of any construction project. The criteria for selecting either EPC or EPCM contractors will be based on the idea of risk sharing. EPC projects are usually more expensive than EPCM ones because the risks are borne to the contractor and not the owner (31 Clifford, 2009, p 6).

The EPC contract is normally priced based on the fixed price method whereas the EPCM makes use of the cost reimbursable method. In the cost reimbursable contract, the risk is the same during the project process irrespective of the project stage. On the other hand, in the fixed price contract a change in the project at the design stage leads to changes in the construction stages.

Nonetheless, they are normally more expensive than EPCM agreements. Thus, the owner will have to consider the advantages and disadvantages of these models. In contrast, according EPCM model, the owner has to take responsibilities because this party will approve and monitor the procurement, engineering and contraction processes. In this case, the owner guides almost every aspect of the project. In the process, the owner has many contracts with construction contractors, subcontractors and suppliers. The owner usually transfers the risk to the contactors. In EPCM contract, the owner has to emphasize the idea of reducing the high cost.

The idea of risk sharing has strong implication for the development of schedule and cost planning. EPC contracts normally increase the cost of construction, especially in comparison with EPCM agreements but the time taken to finish the project is shorter. The company has to weigh between the two and come up with the best choice.EPC companies have both technical and managerial knowledge because they make use of different expatriates with quality skills and knowledge.

When to use EPC

This can be used when the owner does not want to be involved in case of risks in a project (Clifford, 2009).

Limitations of EPC as outlined by Clifford (32 2009, p 8) include:

1. It is costly because contractors will have to charge more for their services due to increased risks that they take.
2. The contractor assumes full control of design, engineering and construction
3. The contractor will prefer minimum standards of compliance.
4. Unwillingness of many contractors to enter EPC agreements. Thus, tender process becomes more time-consuming.
5. As a rule, construction process may take a large amount of time. The owners should pay attention to FEED Stage which the project is designed at a conceptual level.
6. Capacity is low because few contractors have financial capacity to assume the risks related to the project. Some of them may not afford these expenses; this is why they do prefer EPCM agreements.
7. There may be many disputes before the beginning of the project because the contractors will want to eliminate every possibility of financial risks.
8. The transfer of EPC risks can be limited by financial constraints such as bonding limitations.

When to Use EPCM

EPCM is used when the owner wants to have a greater role in purchase of equipments and selecting the contractors. Here the owner takes more control of the project.

Limitations of EPCM as discussed by Clifford (33 2009, p. 11) include:

1. The majority of risks are taken by the owner:
2. Lack of coordination among suppliers;
3. The necessity to prove the fault of contractors.
4. Owner’s legal remedies are diluted: By need to allocate fault, By reduced value of remedies and by limited rights against the EPCM contractor.
5. EPCM model implies that the owner’s choices are significantly limited by earlier decisions of this company.
6. This approach is applicable only to those owners who have significant expertise in construction management and design. Otherwise, this side of the agreement will find it very difficult to protect its interests, especially if any legal disputes occur.
7. EPCM works best within established relationships between experienced parties.

The Use of EPCM and EPC in Saudi Arabia

Due to the taxation legislation adopted in Saudi Arabia, the EPC or EPCM contracts are split into two broad categories, namely Out of Kingdom and In Kingdom contracts (34 Al Amri, p 23). These two agreements are transferred to two different legal entities. They are normally linked with the so-called ‘bridging agreement letter’ that obligates the Out of Kingdom contractor to complete the In Kingdom contract. In many cases, the In Kingdom contractor is a part of a foreign company but it is registered as a separate organization in Saudi Arabia for various legal reasons. Design, engineering, or supply activities are regulated by OOK agreement, while major construction activates are the domain of the IK contract.

In order to reduce the risks of working with separated contractors the oil and gas companies normally prefers to give and sign an EPC contract with the EPC contractor. Although, such a solution is more costly but it ensures that the project will correspond to their requirements and will be completed on time. This is because it is more efficient even though the project delivery method is more time-consuming because it is necessary to make comprehensive design clarifications and discuss every provision of the contract. Still, this framework can be very suitable for oil or petrochemical companies.

The methods of construction contracts can be modified to suit the needs and demands of the owner. The companies usually make choose contracts with the help of financial advisors before launching a particular project.

Reasons for Using EPCM or EPC for Major Projects in Saudi Arabia

According to Damian, Jim, and Marsh (2004) and Kees, (2007) major projects in Saudi Arabia use EPC. The following are the benefits of using EPC as discussed by Clifford (35 2009, p 8):

1. The contractor takes all supply chain risks that are incurred in the project.
2. The transfer of other construction risks is maximized relative to other procurement methods
3. A high degree of certainty is attained as to cost time and quality of work done
4. Remedies like liability caps or bond amounts are determined on the basis of the total construction costs. Therefore, they are more likely to compensate a significant part of the owner’s expenditures or losses.
5. Administrative burdens on the owner are minimized since everything is done by the contractors. The owner saves time because he does not take his time to supervise the project. Everything is left to the contractors.
6. The documentation is relatively simple and standardized and hence it is clear to the owner to see the proceedings of the contract and make accounts of the budget.
7. EPC model is very widespread and it is viewed as the most efficient approach to procurement.
8. This approach to project management sets minimal staffing requirements, and entails minimal legal risk. Overall, it is best for well defined projects that have detailed engineering complete before EPC contract chosen

Other organizations use EPCM contractor because of the following benefits (36 Clifford, 2009, p 10)

1. EPCM works well because it is the most cost-effective method, especially when there is no need to utilize the risk contingency.
2. One can also say that EPCM model is probably the fastest procurement method. By adopting this model, the owners will find the contractors much sooner.
3. The large number of small packages enables the owner to choose from a large pool of contractors.
4. The owner can manage the process of design and smaller changes can be made without running the risk of significant losses.
5. Insolvency and performance failure risks are spread
6. There is staff’s Sense of Ownership
7. Lower overall cost, there is more Control over Process.
8. It is better for the projects which are less defined. Under such circumstances, there is great possibility to design changes.
9. This framework enables both owners and contractors to identify and resolve potential conflicts at early stages. It can prevent expensive and time-consuming lawsuits.
10. It allows owner’s financing flexibility
11. The contractor is responsible for the coordinating the work of other package contractors, including designers.

The Development of EPC Contractors in Saudi Arabia to Shift from EPCM to EPC

There is a trend in construction contracting according to which EPCM agreements are becoming more popular. In turn, EPC contracts are not particularly widespread; still both of these approaches are used by Saudi Arabian companies. Contractors in Saudi Arabia can take both of these approaches. There has been an improvement in cost contract which help in sharing losses and EPCM has gained popularity for international projects and major construction projects (37 Loots and Nick 2007, p 1).

The main difference between EPCM and EPC contracts is that in EPCM contract, the contractor gives qualified and skilled services like designing to the owner of the project. There are so many benefits of using EPC over EPCM. The EPCM has some limitations such as:

1. More risks retained by the owner like risks of interface claims from contractors and risk of burden proving fault in the contract.
2. Owner’s legal remedies are diluted because of the need to allocate a fault in the projects, reduce value of remedies to be taken in the contract and there are limited rights against the EPCM contractor.
3. The later package choices of the owner may be restrained by earlier decisions of this organization.
4. This model sets very high demands the owner’s skills, resources and ability to manage such construction projects. The main problem is that EPCM contractors can have the problems of interest and it will be difficult to reconcile them.
5. This model is more complex from legal point of view.
6. Financing options are limited.
7. EPCM works best within established relationships between experienced parties.

Large EPC contractors are uniquely situated in terms of their close connection with the local society and because of their international expertise. These competencies can increase the social value of a project. One obstacle to realizing this proposition is the owners often forget that such contractors can add extra value to the project and make it more appealing to the community (38 Sawant 2010, p. 235).

For instance, they often create job opportunities for local people and this contributes to the positive reputation of the entire project. More attention should be paid to early involvement of contractor, award discussions as well as project collaborating. This will make an EPC contract much more specific and clear to both sides. In EPC companies the contractor takes full responsibility of everything in the project in respect to cost of the project, the time for completion is short and also the quality of the work and achievement is guaranteed.

Conclusion

EPC (Engineering Procurement and Construction) and EPCM (Engineering, Procurement, Construction and Management) contracts are the most used in the oil and gas projects in Saudi Arabia. The paper has discussed the differences between the two contracts and how risks are taken in the contracts and how they are used in oil and gas industry in Saudi Arabia. An EPC contract is a plan and construction contract in which one contractor has responsibility for the project as a whole while an EPCM contract is where skilled services are given and risk allocation is different. In EPCM contract other subcontractors build the project while in EPCM the contractor does not construct the house.

Before making the choice of the contractors, the owner has to know the risks that are incurred in the projects and have idea about the contractor’s limitations in dealing with risks and cost. An EPC agreement offers a convenient framework for those projects that require significant expertise in design. The initiator of the project does not have to take full control over design and construction. These agreements are more suitable for large-scale constructions projects such as oil refineries or petrochemical facilities.

EPC contracts are usually complicated in terms of legal issues and therefore it is advisable for the owners and contractors must have in-depth knowledge of about the construction that they are going to undertake. Otherwise, one of the parties runs the risk of enormous losses. Moreover, there is great likelihood of various legal disputes. There are several indispensible conditions for good social performance during the construction of manufacturing facilities. One of them is high qualification standards that prompt various bidders to rely on international experience and those projects which were completed in similar political, social, and economic environments.

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