THE SHORT AND LONG TERM IMPACTS OF THE LOW OIL PRICE ENVIRONMENT ON FPSO CONTRACTORSCompared to just one year ago, oil prices have plummeted more than fifty per cent, in turn pressuring oil companies, FPSO contractors, and subcontractors to focus on reducing capex and implement cost cutting measures. However the effects of the low oil price on the industry are far greater than they may first appear, particularly for contractors, having repercussions through every part of the business from contracting, to operations and even talent.

Only three contracts totalled around $1.5 billion were awarded this year, according to a report from Douglas Westwood in June this year. These are-- a conversion in Ghana for Eni-operated Offshore Cape Three Points (OCTP) Block, another conversion in Iran and an upgrade in Indonesia. Compare this to H1 2014 when there were six orders, and each of significantly higher value. FPSO contract awards are expected to face significant delays until there is better visibility of the oil and gas industrindustry. At present, analysts believe that the FPSO industry will remain in this relative slump until at least 2H 2016.

The low number contract awards will see more intense competition. Over the years, we have seen newer FPSO players such as Bumi Armada, EMAS, Yinson Production, M3Nergy and more all tendering aggressively. In the FSO segment, we also see Malaysian newcomer, EA Technique who won the FSO for Hess’ Bergading project this year, bidding for more projects. With more players preying on lesser projects, margins will shrink.

Naturally, cost cutting measures are an impending solution. To cut fix costs, SBM Offshore already announced in December last year that they were retrenching approximately 1,200 positions, citing market conditions as the cause. Many more companies have already followed suit, laying off staff or trimming expenses, albeit not announcing it publicly.

Fewer contracts

Lower margins

More cost cutting measures

Cost overruns resulting from

underbids

Employee replacement issues

Survival of the fittest

In light of the current market conditions, newer and inexperienced FPSO contractors may slash their prices in order to win orders. This may be done without proper cost budgeting, or what is known as “optimistic cost budgeting”. The latter refers to cost budgeting in anticipation that future material and equipment costs will be negotiated down considerably. This type of costing procedure is however liable to backfire if market conditions rebound in a short period of time. Material and equipment costs will then rise again, causing cost overruns above the initial budgets.

Cost overruns can also arise when companies underestimate maintenance and service costs during tender. This is especially in the case oespecially in the case of FPSOs which have been converted from old tankers and already possess maintenance and servicing issues.

Likewise, any savings achieved by “cutting corners” in regarding to fabrication, equipment specifications or maintenance expenditure will definitely hurt companies later on. Most FPSOs have an onsite lifespan of at least 20 to 25 years without access to dry-dock or repair facilities. Any mishap or repair will haunt FPSO contractors later when significantly higher costs will be incurred than what could have been saved upfront.

Take for example the Modec Venture 11 FPSO which was offline for the entire second quaquarter this year. The FPSO had problems associated to her internal turret. On 31 July this year, Modec reported that the repair cost and decrease in revenue due to production suspension is estimated to be approximately 2 billion yen (US $16 million). The FPSO has since resumed operation.

The FPSO industry is a niche and knowledge-intensive industry which already suffers from a lack of experienced human assets. This problem will only get worse if FPSO layoffs become more widespread. While laying-off employees provides short term savings, companies may encounter difficulty replacing their experienced staff in the long term once the market recovers. The market downturn may also cause experienced staff who were not affected by the cost cutting and retrenchment programs to also leave. This is liable to stem from difficulties to carry out work efficiently with too many “gaps” left by recently departed colleagues.

If the low oil price environment persists into the long-term, we can expect to see more corporate restructuring, M&A activities and asset sales. Furthermore, since FPSOs are usually designed for specific field developments and are not easily redeployable, this means that any postponement or cancellation will lead to more idle assets with high residual values.

Smaller or wSmaller or weaker FPSO companies will be hit hardest in this kind of situation. Their weaker financial balance sheets and lack orders will make it tough for them to withstand the crisis. To survive, they will be tempted to underbid projects, despite not having a strong project management or delivery track record. This will create a vicious cycle and may eventually lead to collapse of several market playersplayers. We may recall that during the global financial crisis in 2008, when finan-cial institutions tightened their lending, projects were either delayed or cancelled. As a result, several FPSO contractors went into bankruptcy and their assets were sold.

Although all FPSO contractors will have to weather the current short term challenges, the long term view of the FPSO market remains sound. Furthermore, many analysts have predicted that the demand for oil will grow at a steady pace over the coming decades while supply will be tight, eventu-ally driving the oil price up again.

According to Energy Maritime Associates, there will be 105 - 188 Floating Production Systems award-ed over the next five years. The total capital cost of these awards is estimated at between US $80.2 - 157.4 billion. It is also anticipated that FLNG and FSRU will see increase orders due to the greater availability of financing available for small to mid-size LNG related projects. Nevertheless, FPSO is still expected to be the largest category with 45% of predicted orders and 60% of estimated capex.

To conclude, FPSO is a highly risky business with specific field requirements and redeployment chal-lenges. As a result, the accuracy of cost budgeting highly depends on meticulous planning upfront. The competency/track record of the stakeholders executing projects is also critically important to the long term success of a company. Consequently, FPSO contractors must be judicious when they are considering cost cutting measures in the current environment. In the effort to mitigate their short term challenges, companies may incur cost overruns and schedule delays in the long term. Ultimate-ly, oil companies should not focus only on imposing tougher pricing/ terms and conditions against contcontractors. The best solutions should be for both parties to work closely together to overcome the current crisis.